GFL - Clean Harbors Is A Good Buy At The Current Levels

2023-08-29 14:08:04 ET

Summary

• Clean Harbors' revenue growth is expected to benefit from favorable pricing and resilient demand in the Environmental Services segment.
• The company's revenue increased in Q2 2023, driven by strength in the Environmental Services segment, offsetting the slowdown in the Safety-Kleen Sustainability Solutions segment.
• Clean Harbors is well-positioned to capitalize on ongoing trends such as reshoring, rapid industrialization, and increased government regulations in the waste management industry.

Investment Thesis

Clean Harbors' ( CLH ) stock is up over 20% since my bullish article in March. Looking forward, in the near term, CLH's revenue growth should benefit from favorable pricing and resilient demand in the Environmental Services ((ES)) segment which should help the company more than offset the slowdown in the Safety-Kleen Sustainability Solutions (SKSS) segment. In the long run, the company’s revenue growth is poised to benefit from ongoing trends such as reshoring, increased government regulations in the waste management industry, and the government funding from the Inflation Reduction Act (IRA) and CHIPS and Science Act.

On the margin front, while compression in re-refining spreads in the SKSS segment remains a near-term headwind, the comps are easing from Q4'23 and the company should benefit from cost-cutting measures across its North American operations and the integration of the Thompson acquisition in the coming quarters. Moreover, the valuation is lower than its 5-year historical average and is attractive compared to its peers. Therefore, I maintain a buy rating on CLH stock.

Revenue Analysis and Outlook

Post-Pandemic, CLH witnessed a boost in its revenue growth fueled by robust demand in its Environmental Services and Safety-Kleen Sustainability Solutions segments. The acquisition of HydroChemPSC in Q4 FY21 further contributed to revenue growth.

In the second quarter of 2023, the ES segment's revenue (accounting for ~84% of total revenue in Q2 FY23) benefited from a favorable mix of high-value waste and pricing initiatives. Each of the segments' four business units saw a year-over-year increase in revenue. This resulted in a 7.4% YoY increase in ES segment revenue to $1.172 billion. However, the SKSS segment’s revenue (accounting for ~16% of total revenue) declined 14.7% YoY to $226 million due to adverse supply-side dynamics and lower market-based pricing on base oil product sales. On a consolidated basis, the company’s revenue increased 3% YoY to $1.4 billion driven by strength in its ES segment which more than offset the slowdown in the SKSS segment.

Looking forward, the company is poised to benefit from strong trends in its ES segment which should more than offset the slowdown in the SKSS segment in the near term.

The company's ES Segment backlog is at record levels following the unplanned weather-related outages at Deer Park and El Dorado facilities in December 2022 as well as in Q1. Over the last couple of quarters, the company has focused on maintenance and repair at its disposal facilities to address these outages, and as a result, utilization at the incinerators reached 84% in Q2 2023, an increase of 4 percentage points sequentially vs Q1 2023. As incineration utilization continues to improve, the company is well-positioned to convert its increased backlog and drive revenue growth in the second half of this year. Further, the company plans to continue raising prices in its ES segment. As a result, the company’s revenue growth in the ES segment should also benefit from both carryover benefit from previous price increases as well as future price increases.

In the long run, CLH is expected to continue benefiting from the ongoing reshoring trend, particularly in the electronics, chemicals, water treatment, and medical equipment industries. Also, the emerging PFAS opportunity should create additional long-term revenue streams.

The US government is currently implementing multiple initiatives to revive US manufacturing to increase high-income technical jobs, strengthen supply chains, and promote sustainable development. These initiatives include the CHIPS and Science Act (which is incentivising onshore semiconductor and other manufacturing facilities) and the Inflation Reduction Act (which is incentivising EV and related component production) to encourage US manufacturers to bring their production back to the country, leading to a surge in manufacturing activities. The increase in manufacturing will drive higher volumes of waste and, hence, more demand for waste disposal services. Given the CLH's broad market presence and large installed base, it is poised to benefit from the growing demand for waste disposal services fueled by these government initiatives.

Another area for long term growth is Per- and Polyfluoroalkyl substances, or PFAS. These are a class of widespread man-made compounds commonly referred to as " forever chemicals. " As their name suggests, they are neither biodegradable nor safe for humans or the environment and have been identified as major pollutants in water sources across the country. According to the management, the high-temperature thermal destruction in incinerators is the most effective and efficient way to eliminate PFAS, and the U.S. Department of Defense recently made a decision to lift the PFAS incineration ban. This should increase the demand for the company’s services. CLH has identified a $40 to $50 million opportunity this year, and as regulatory clarity improves, it should open up more opportunities for the company to work with major government agencies, providing a more secure and long-term revenue stream. Further, with increased government regulation, a lot of private players are increasingly preferring third party waste management service provider like CLH. A recent example of this is 3M ( MMM ) discontinuing its 30,000 tons Cottage Grove incinerator in favour of Clean Harbours services.

Moreover, the company is actively investing in CapEx to increase its incineration capacity and deal with increased volumes of waste fueled by above-mentioned factors. The company is on track to complete its new state-of-the-art incinerator in Kimball, Nebraska, by early 2025, and is planning to spend $85 to $90 million on the project this year.

Further, CLH should also benefit from strategic M&A activity. Over the past few years, the company has pursued small tuck-in acquisitions as well as larger acquisitions (eg. the HydroChemPSC acquisition for $1.25 billion in 2021) in order to diversify its end markets. The recently completed Thompson Industrial acquisition expands the company's presence in the Southeast US and broadens its position in verticals including paper, mining, and power. Cross-selling opportunities offered by the Thompson acquisition helped the company's industrial services business grow by 11% YoY in Q2 FY23 and should continue to drive growth in the business moving ahead. The company has a healthy balance sheet with net debt-to-EBITDA of ~2x (as of Q2 FY23 end) which should enable it to pursue further inorganic growth opportunities moving ahead.

While there are near-term headwinds in the SKSS segment due to declining base oil prices, this segment is relatively small and the strength in the ES segment should more than offset any decline in this segment. The long-term outlook for the company looks promising with revenue growth benefiting from ongoing reshoring trends helped by government funding. The DoD's decision to lift the PFAS moratorium is also good news for the company’s long-term growth prospects. These factors, coupled with the company's leading market presence, make me positive about the company's revenue growth prospects.

Margin Analysis and Outlook

Following the pandemic, the CLH’s Safety-Kleen Sustainability Solutions segment, which deals with re-refining and recycling oil products, saw a significant margin improvement due to higher oil prices. However, late last year and in early 2023, the company started seeing weaker-than-normal seasonal pricing due to the decline in base oil prices, which has resulted in compression in the re-refining spread and lower SKSS segment margins in recent quarters. As a result, in Q2 2023, the company witnessed a 230 bps YoY decline in the total adjusted EBITDA margins to 20.5%. The compression in margins was somewhat offset by the 140 bps YoY margin improvement in the Environmental Services segment, driven by high volume leverage, pricing actions and productivity gains.

Looking forward, while there are near-term headwinds for margins due to the compression in re-refining spread, the company should be able to partially offset it through margin growth in the ES segment and integration of Thompson acquisition.

Due to falling base oil prices, the SKSS segment's margins saw significant pressure in the last quarter. Considering the adverse market conditions in the base oil marketplace in the quarter, the company took proactive action to reduce costs associated with the procurement, transportation, and processing of used oil and switched quickly from a pay-for-oil to a charge-for-oil pricing model. This shift in the pricing model helped to partly mitigate the impact of falling base oil prices on the SKSS segment's margins and should position the company for better profitability in the coming quarters as base oil prices stabilize. While adjusted margins for SKSS were down significantly Y/Y, the good thing is that they improved sequentially in Q2 versus Q1. The third quarter still has tough Y/Y comparisons, but comparisons will meaningfully ease from the fourth quarter which bodes well for the margins later this year and in the next.

While there are near-term headwinds on the SKSS segment’s margins, the ES segment margins continue to be strong thanks to price increases and cost-cutting measures. According to management , the average incineration price was up 8% in Q2. The company is targeting ~$100 million in cost reductions in 2023, mostly in the ES segment which includes reduction in rental and corporate costs. Further, the company is targeting ~$12 million contribution to adjusted EBITDA from the integration of the Thompson acquisition through savings on labor and increased cross-selling opportunities.

While Q3 2023 will likely be another quarter with Y/Y decrease in margins, the company should return to margin growth in Q4 2023 and beyond thanks to easing comparisons in SKSS segment, cost cutting initiatives and pricing increases in the ES segment. So, I hold an optimistic outlook on CLH’s medium to long-term margin growth prospects.

Valuation and Conclusion

The company is currently trading at a forward P/E of 21.37x FY23 consensus EPS estimate of $8.03 and a 19.83x FY24 consensus EPS estimate of $8.65. Over the last five years, the company’s stock has traded at an average forward P/E of 35.16x. Further, compared to its peers like Republic Services ( RSG ) which is trading at a P/E of 27.13x based on FY23 consensus EPS estimates and GFL Environmental ( GFL ) which is trading at a P/E of 39.54x based on FY23 consensus EPS estimates, the company’s valuation appears attractive.

I believe CLH’s stock offers a good buying opportunity for long-term investors. The company’s long-term growth prospects are supported by factors such as the ongoing reshoring trend among US manufacturers, government funding, and the emerging PFAS opportunity. Further, strategic acquisitions should continue to broaden the company's service offerings across different markets. The company’s medium to long-term margin growth outlook also looks favorable, with price increases, cost-cutting measures and easing comps from Q4 2023 serving as a tailwind. Additionally, the company’s valuation is reasonable. Hence, I have a buy rating on the stock.

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