HCCI - Heritage-Crystal Clean Has Long-Term Tailwinds In Its Favor

Summary

• Heritage-Crystal Clean has a 20+ year record of strong revenue growth.
• Although fragmented, it operates in an industry with significant barriers to entry and where the firm is the second largest competitor.
• The firm has been able to grow profitably, earning investors good returns.
• The addressable market is large, at over $8 billion, and the firm is well poised to do well in the future.

Heritage-Crystal Clean, Inc. ( HCCI ) has excelled over the last five years on the stock market. That success is built on a business model with significant competitive advantages, including barriers to entry. Those conditions have enabled the firm to grow profitably over the last five years. Indeed, over the last twenty years, the firm has shown very strong growth, with revenue growing at 17.8% compounded between 2000 and 2021. The firm is trading cheaply and has a reasonably attractive FCF yield of 4.46%.

Excellent Stock Market Performance

In the last five years, Heritage-Crystal Clean has gained nearly 76%, while its benchmark indices, the NASDAQ Industrials, and NASDAQ Composite, have gained nearly 43% and over 63% respectively.

In the last year, the stock has gained more than 30%, while the NASDAQ Industrials and NASDAQ Composite have slumped nearly 16.6% and more than 18%, respectively. The company’s success on the stock market is founded on a strong underlying business model, and favorable competitive conditions.

The Business Model

Heritage-Crystal Clean is a company that provides industrial and environmental services, primarily in the areas of parts cleaning, used oil re-refining, and hazardous and non-hazardous waste management. According to the firm’s 2021 annual report , Heritage-Crystal Clean is the “second largest provider of full-service parts cleaning, hazardous and non-hazardous waste services and used oil collection services to small and mid-sized customers in both the industrial and vehicle maintenance sectors in North America”. The report also states that it is “the second largest used oil re-refiner by capacity in North America, and the second largest producer of remanufactured antifreeze in the United States”.

Strong Financial Performance

Revenue grew from $365.96 million in 2017 to $515.33 million in 2021, at a 5-year revenue compound annual growth rate ((CAGR)) of 7.09%. Data from Credit Suisse’s ( CS ) The Base Rate Book shows that 24.2% of firms experienced a similar rate of growth over a 5-year period. The mean 5-year revenue CAGR in the 1950-2015 period was 6.9%, and the median was 5.2%. In the first nine months of 2022 ended September 10, the firm earned $468 million, compared to $$346 million for the same period in the year prior.

Revenue is derived from two segments: Environmental Services and Oil Business. The Environmental Services segment encompasses parts cleaning, containerized waste management, wastewater vacuum, antifreeze, and field services. These services help customers handle and dispose of hazardous and non-hazardous waste, including parts cleaning solvents, which are subject to strict regulations. The company aims to make its services easy to use for customers and reduce the burden of industrial and hazardous waste management. Heritage-Crystal Clean has introduced innovative programs, such as the exclusion of used parts cleaning solvent from the definition of hazardous waste, to simplify the management of waste and reduce the overall regulatory burden. The company also offers containerized waste management, wastewater vacuum services, antifreeze services, and field services that help customers manage their waste efficiently and safely. These services include characterizing and labeling of waste, in-house treatment of wastewater, antifreeze recycling, and tank cleaning and spill cleanup. The parts cleaning services business is the second largest full-service provider in the United States. The revenues from parts cleaning are highly recurring and mostly under automatically renewing service contracts.

The Oil Business segment includes activities such as collecting used oil, re-refining it, providing oil filter removal and disposal services, and selling recycled fuel oil. The company recycles used oil into high-quality lubricant base oil and other products through its re-refining process, and supplies these products to companies that manufacture and sell finished lubricants. By participating in this program, customers can positively impact the environment by reducing their use of crude oil for lubricant production, which has been found to be more energy-intensive. Heritage-Crystal Clean operates a used oil re-refinery with a capacity of 50 million gallons of lubricant base oil per year. The re-refinery is fed with a combination of used oil collected from customers and used oil purchased from third parties. The segment is the second largest used oil collector and re-refiner in North America.

The Environmental Services segment is responsible for 62% of revenues, while the Oil Business is responsible for 38% of revenues.

HCCI April 2012

Gross profitability rose from 0.29 in 2017 to 0.31 in 2021. This is slightly short of the 0.33 threshold that Robert Novy-Marx’ research found marked a stock out as attractive. Nonetheless, this shows a growing ability to earn profits. This is especially impressive when you consider that the firm has had fairly strong asset growth during that period, with assets growing from $314.66 million in 2017 to $526.86 million in 2021, at a 5-year total assets CAGR of 10.86. This suggests that asset growth has been deployed in value generative ways.

Operating income has more than doubled over the 2017-2021 period, rising from $35.43 million in 2017, to $83 million in 2021, at a 5-year operating income CAGR of 18.56%. In the first nine months of 2022, ended September 10, the firm earned an operating income of $33.05 million, compared to $24.86 million for the same period in the year prior. Operating margin rose from 9.41% in 2017 to 16.11% in 2021. This puts the Heritage-Crystal Clean’s operating margin in the third tier of operating margins. However, in terms of the industrials sector, the firm’s results are very good, given that industrials had a mean operating margin of 8.1% in the 1950-2015 period, and a median operating margin of 8.5%. In the first nine months of 2022 ended September 10, the firm had an operating margin of 16.37, a decline from 16.84% for the same period in the year prior.

Net income shot up from $28.12 million in 2012, to $60.95 million in 2021, at a 5-year earnings CAGR of 16.73%, giving us a base rate of 20.03% of firms with a similar rate of growth over a 5-year period. The mean 5-year earnings CAGR for the 1950-2015 period was 7.3% and the median was 5.9%.

While long-term debt has risen from $28.74 million to $65.04 million in 2021, for a 5-year long-term debt CAGR of 17.74%, long-term debt remains a marginal source of capital for the firm. In the first nine months of the year ended September 30, long-term debt had risen to $93.95 million. Consider that the firm has increased its cash and cash equivalents from $41.89 million in 2017 to $56.27 million in 2021, at a 5-year cash and cash equivalents CAGR of 6.08%. So, a substantial portion of long-term debt could be settled with the firm’s cash and cash equivalents.

Heritage-Crystal Clean has increased free cash flow ((FCF)) from $30.93 million in 2017 to $66.96 million in 2021, at a 5-year FCF CAGR of 16.7%. In that time, FCF margin has risen from 8.45% in 2017 to 12.99% in 2021. Over the TTM period, the firm has gained $48.66 million in FCF. FCF margin has declined to 7.63%.

Returns on invested capital ((ROIC)) have risen from 16.8% in 2017 to 23.3% in 2021, placing it at the top tier of ROIC. This confirms our earlier notion that management has been able to intelligently allocate capital over the last five years. In the TTM period, ROIC has risen further, to 24.3%.

Large, Attractive Market

Having confirmed that management is able to allocate capital profitably, we can then consider Heritage-Crystal Clean’s growth opportunities. After all, we do not want to invest in a business that is not earning its cost of capital. The firm has a large, attractive market ahead of it. Management estimates that its addressable market is worth $8.1 billion. The biggest source of growth comes from the industrial and hazardous waste market, which is 62% of Heritage-Crystal Clean’s addressable market.

In the United States, management estimates that there are around 81,000 places where manufacturing or vehicle maintenance takes place. These establishments need grease and dirt removed from parts, using industrial cleaning solutions. These establishments produce used oil, waste paint and other products that they cannot easily dispose of, creating an environmental, waste disposal, and regulatory headache. Rather than dealing with the problem themselves, it is cheaper for those businesses to have a firm like Heritage-Crystal Clean tackle the problem. Thus, Heritage-Crystal Clean acts to reduce costs, and risks for these establishments. The market has, as you can imagine, been growing for a long time, and will continue to grow for a long time. The secular nature of this growth is evident in Heritage-Crystal Clean’s revenue growth over the last twenty years, in which it has grown revenues by a CAGR of 17.8%.

Barriers to Entry

While the industry is highly fragmented, with many small, single-city or regional peers, profitability is difficult to achieve. The firm’s major competitor is Clean Harbors, Inc. ( CLH ), who acquired Safety Kleen in 2012. In order for Heritage-Crystal Clean or its peers to be profitable, they have to offer route density. Furthermore, it is difficult to acquire and maintain spill response certifications such as Oil Spill Response Organization ((OSRO)) certification. It is not just spill response certifications that are hard to get: permits for transportation and for operating sites are costly and difficult to get. The capital outlay needed to offer parts cleaning equipment to customers is prohibitive. This is also true of the capex needed to build a meaningfully large used oil re-refining plant, which costs upwards of $100 million. Finally, any peer seeking to challenge Heritage-Crystal Clean or Clean Harbors, will have to build an extensive branch and supporting transportation network and even if they had the capital, it would take time to build out, time in which Heritage-Crystal Clean and Clean Harbors could act to increase the barriers to entry.

When you look at Heritage-Crystal Clean's competitive advantages, it is easy to see why the firm is unlikely to be topped as a top 2 actor in the industry:

1. Experienced and knowledgeable personnel: The company has a highly trained and experienced team of professionals who are knowledgeable about the industry and dedicated to providing the best possible services to its customers.

2. Proprietary technology: Heritage-Crystal Clean uses proprietary technology and processes to clean parts, recycle used oil, and manage hazardous waste. This gives the company a unique advantage over its competitors in terms of quality, efficiency, and environmental responsibility.

3. Strong commitment to sustainability: Heritage-Crystal Clean is dedicated to reducing its environmental impact and promoting sustainable practices. The company invests in new technologies and processes to minimize waste and reduce its carbon footprint.

4. Strategic partnerships: Heritage-Crystal Clean has established strategic partnerships with leading companies in various industries, which allows the company to offer a wide range of services and solutions to its customers.

5. Nationwide presence: With a nationwide network of locations, Heritage-Crystal Clean is able to provide its services to customers across North America. This allows the company to serve a large and diverse customer base and to respond quickly to customer needs.

Valuation

Heritage-Crystal Clean has a price-earnings ((PE)) multiple of 11.66, compared to the S&P 500, which has a P/E multiple of 22.02 . Not only is the firm undervalued relative to the S&P 500, but its FCF is as well. With $48.66 million in FCF in the TTM period, and an enterprise value of $1.09 billion, the firm has an FCF yield of 4.46%. This is an attractive FCF yield considering that the mean FCF yield of the 2000 largest firms in the United States is 2.1% , according to New Constructs. The firm’s FCF is, therefore, cheaper than that of the general market.

Conclusion

Heritage-Crystal Clean has excelled over the last five years on the stock market. The company has displayed strong operating and financial results over that five-year period. In addition, the firm operates in a large and fast growing market, in which it has meaningful competitive advantages and where there are significant barriers to entry. Those favorable conditions make the firm an attractive long-term target. The company’s cheap relative valuation and cheap FCFs are the final signal investors need to consider the firm as a long-term investment.

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