HCCI - Mittleman - Heritage-Crystal Clean: Great Track Record Not Enough Credit

• Mittleman Investment Management bought a 2.5% weighting in Heritage-Crystal Clean Inc.
• HCCI is a growth/cyclical business whose valuation is penalised too much by the cyclical exposure with not enough credit for the great track record and prospect of continued growth.
• If energy prices stay somewhat elevated, the better-than-normal spread HCCI’s re-refining business has enjoyed recently might persist for some time.

The following segment was excerpted from this fund letter .

Heritage-Crystal Clean Inc. ( HCCI )

Mittleman Investment Management, LLC. (MIM) bought a 2.5% weighting in a leading environmental services company that Chris Mittleman has admired for many years, Heritage-Crystal Clean Inc. ( HCCI ) , at an average cost of $26.77 in the waning days of June, with ~49% upside to MIM’s estimate of fair value at $40.

As at 1 August the shares are $34, up recently on a stronger than expected quarterly report announced on 27 July, and a large insider buy of 150,000 shares on that same day at $27.00 ($4.05M), bringing CEO Brian Recatto’s total shares directly held to 820,505 ($28M).

MIM’s estimate of fair value for HCCI of $40 is based on a $901M EV = 8.6x EBITDAaL (est. for CY2022) of $105M (17.5% margin on $600M sales) = 18x FCF est. of $50M. Closest competitor, Clean Harbors / Safety-Kleen (CLH $90) trades at 8.5x EBITDA (est. 2022) and 18x FCF (CLH has roughly same EBITDA margin as HCCI, despite being 8x larger).

Below a description of the company from the most recent 10-Q:

Heritage-Crystal Clean, Inc., a Delaware corporation and its subsidiaries (collectively the “Company”), provide parts cleaning, hazardous and non-hazardous containerized waste, used oil collection, wastewater vacuum, antifreeze recycling and field services primarily to small and mid-sized industrial and vehicle maintenance customers. The Company owns and operates a used oil re-refinery where it re-refines used oils and sells high quality base oil for use in the manufacture of finished lubricants as well as other rerefinery products.

The Company also has multiple locations where it dehydrates used oil. The oil processed at these locations is primarily sold as recycled fuel oil. The Company also operates multiple non-hazardous waste processing facilities as well as antifreeze recycling facilities at which it produces virgin-quality antifreeze. The Company’s locations are in the United States and Ontario, Canada.

The Company conducts its primary business operations through Heritage-Crystal Clean, LLC, its wholly owned subsidiary, and all intercompany balances have been eliminated in consolidation.

The Company has two reportable segments: “Environmental Services” and “Oil Business.” The Environmental Services segment consists of the Company’s parts cleaning, containerized waste management, wastewater vacuum, antifreeze recycling activities, and field services. The Oil Business segment consists of the Company’s used oil collection, recycled fuel oil sales, used oil rerefining activities, and used oil filter removal and disposal services.

No customer represented greater than 10% of consolidated revenues for any of the periods presented. There were no intersegment revenues. Both segments operate in the United States and, to an immaterial degree, in Ontario, Canada. As such, the Company is not disclosing operating results by geographic segment.

For those seeking more detail, the company’s website is highly informative: www.crystal-clean.com

This is a growth/cyclical business, with about 40% of sales from re-refining of used oil, and 60% from less cyclical environmental services. MIM thinks the valuation is penalised too much by the cyclical exposure with not enough credit for the great track record and prospect of continued growth.

The oil re-refining business is operating at an all-time high for HCCI recently, so that is likely to flatten out and with the obvious risk that it might more severely revert to the mean. But then again, if energy prices stay somewhat elevated the better than normal spread HCCI’s re-refining business has enjoyed recently might persist for some time. The cost of the used motor oil that HCCI collects from its various customers has risen, but not as much as the re-refined products which HCCI sells, mostly Group 2 Base Oil that goes into various lubricants.

Also, IMO 2020 (International Maritime Organization) regulations implemented on 1 January 2020 impose stricter sulfur limits on marine fuel, which increases demand for HCCI’s clean (low sulfur) fuel output.

MIM’s willingness to endure the risk that the oil re-refining business is unsustainably over-earning is because the environmental services side of the business (60%) holds a more than offsetting amount of appeal, both from organic growth expectations and from acquisitions, like the $156M purchase of Patriot Environmental Services announced on 30 June 2022 .

On the 28 July Q2 earnings report conference call, HCCI’s management quantified the valuation paid for Patriot Environmental as 5.5x actual 2021 EBITDA, but 9x normalised 2021 EBITDA (excluding one big unusual contract). But, after cost saving synergies expected in year 1 of $7M, the post-synergies multiple paid drops back to 6.5x. A seemingly smart deal that is a continuation of their 22-year track record of growing organically and with accretive M&A.

There is also a large valuation gap, not just between HCCI and its larger peer, CLH, but between their sector and the large solid waste companies, which do have much higher EBITDA margins but still the valuation gap seems excessive. MIM’s suspect larger solid waste haulers may seek to buy out specialty environmental services companies like HCCI and CLH.

Lastly, controlling shareholder, Heritage Group Inc. (Fred Fehsenfeld Jr., 71 years old), which owns 20.6% of the HCCI shares outstanding, registered their shares for sale last year. That may be meaningless, but it might indicate an openness or preparation for potential sale. Fehsenfeld also controls Calumet Specialty Products ( CLMT ), which is somewhat similar to HCCI’s oil re-refining business. His 20.7% stake in HCCI is worth $168M, and his 15% stake in CLMT is worth $146M, both at today’s (August 1st) share prices.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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