2023-11-29 11:15:42 ET
Summary
- Quest Resource Holding is a provider of waste and recycling services to large US companies with an intriguing asset-light business model.
- Despite several acquisitions, Quest's growth in 2022 and 2023 has been slow.
- Quest is dedicating a lot of its cash flow to paying interest on an expensive loan used to finance the acquisitions.
- Until growth picks up or Quest finds a way to bring down its interest burden, I'm staying on the sidelines.
Quest Resource Holding (QRHC) is a stock I've been following for a while. It's a company I want to like: It offers an interesting asset light business model and it appeals to my soft spot for waste and recycling stories (stable demand, secular growth for recycling and very needed services in general).
However, two things have kept me away. The company carries a lot of expensive debt and their results aren't showing the kind of growth I would like. On revisiting the stock after the Q3 2023 results, this remains the case. For now Quest will stay on my list of future ideas - or regrets, as the case may be.
The Quest model
So who are Quest? In their own words, they are "a national provider of waste & recycling services to large businesses" with their investor presentation listing some impressive brands as customers.
What in theory sets Quest apart is that they sell waste and recycling services but outsource the actual delivery of these services to subcontractors. They are an intermediary that, at least in theory, adds value by identifying how a specific customer's waste streams are best managed and recycled. Once that is done, they outsource the work to the vendors best suited to those specific waste streams (as a note, this and the following paragraphs are based on Quest's most recent 10K as well as the investor presentation linked above).
The theory is that customers will only have to deal with Quest, who is free to choose whatever method works best for the specific waste streams without being limited by needing to consider utilization of their own infrastructure. Quest also claims to be able to offer advanced and automated reporting to clients aggregated across vendors, which should be valuable as large brands increasingly need to demonstrate they are managing their waste streams in a sustainable way. The final piece in the Quest value proposition is their claimed expertise in helping recycle waste streams instead of sending them to landfills (again, valuable to large brands with ESG goals to meet).
For the vendors Quest works with, they should benefit from having Quest bring work to them and so provide access to clients the subcontractors might not be able to reach on their own. As Quest explains it, they have long-standing contractual relationships with their vendors - as in, Quest are doing more than just brokering individual transactions and so are presumably at less risk of disintermediation.
That's at least the sales pitch. In reality, I suspect things are more complicated. Vendors could consolidate to grow in both scale and breadth of services, while on the customer side the large national brands Quest focuses on in theory have the resources to move the work in-house (if they could do so cost effectively is a different question). Despite having contracts with their subcontractors it does seem like there will unavoidably be some risk of customers and Quest's subcontractors coming together and cutting out the middleman, which indeed also figures among the risk factors listed in Quest's 10K .
An intermediary model like this has worked in many other industries, however, so it could also work here. The value proposition as Quest explains it makes a certain intuitive sense to me. As an asset light model, it should be possible to scale it up quickly, if it works, so what I would like to see from Quest is sustained growth as a proof of concept.
Quest results
Quest made a large acquisition at the end of 2021 , so comparisons of current results to 2021 and prior years are difficult. Instead, I'll focus on the 2022 and 2023 results. Quest did make one small acquisition in 2022 , but it was tiny and seems unlikely to have a material impact. With the 2021 acquisition now almost two years in the past, I would also hope to see some synergies showing up in the form of increased profits.
I'll focus on gross profit, mainly because that's how Quest themselves says their business is best measured given their revenue includes pass-throughs of various commodity prices. To quote Quest's CFO from their most recent earnings call :
A quick note about the sequential decrease in revenue. It was primarily related to commodity price fluctuations and normal quarterly volume fluctuations. As discussed on previous calls, commodity price fluctuations have not historically had material effects on gross profit dollars. Our customer agreements produces consistent gross profit dollars, based on volumes that are not tied to commodity price fluctuations. For those of you new to the story, this is the reason we use gross profit dollars as a key metric to measure financial performance.
Using that as the primary metric unfortunately does not show major growth in 2023:
On earnings calls , Quest has given some explanations for growth not being higher in 2023: Economic sentiment making it hard to get new national customers to close on contracts, specific problems with integrating the major acquisition from 2021 and ramp up of new customers taking time (while Quest is asset light, the waste is real and each customer location might need to change working practices if waste streams are to be handled differently).
Those reasons may very well be true. However, even if so, I prefer waiting on the sidelines until I see growth showing up more clearly.
Expensive debt
The reason I'm not in any hurry is the expensive debt Quest is carrying. The company made several acquisitions in 2020, 2021 and 2022 which were financed with a term loan from Monroe Capital. That loan has an interest rate of SOFR plus a margin of between 5.50% and 7.50% depending on leverage ratio. With current SOFR rates that leaves Quest paying almost 12% interest on the loan. That's not ideal, considering it makes up the bulk of their ~$60 million in debt:
Now, this table also shows that Quest's debt has gone down ~$14 million in the first nine months of 2023 with Quest understandably making paying down the Monroe loan a priority. Looking at the cash flow statement for the period , the company only generated ~$6.7 million in cash flow from operations. Backing out working capital changes would reduce that number by about a million. The $14 million reduction in debt has, in other words, not been done solely through cash flow, but also by the company decreasing its cash position from ~$9.5 million at the start of the year to ~$1 million at the end of Q3.
There's nothing wrong with using excess cash to pay down expensive debt, of course, but it does show debt paydown will be a relatively slow affair at Quest's current levels of cash flow. That's a problem given how large the associated interest cost is: For 2023 year to date, to put things into perspective, Quest had operating profit of ~$3 million and paid interest of ~$6.5 million. If problems were to occur in the business, there's little room for maneuver. This debt burden must surely also be restricting Quest's ability to invest in growth, or at the very least force them to be extremely deliberate about it.
Growing through M&A seems difficult given this debt load, putting a premium on the company being able to produce organic growth above what has been seen in 2023 so far.
Conclusion
For now, I'm keeping a watching brief when it comes to Quest. If their growth starts to accelerate and/or Quest finds a way to make their debt less scary, perhaps by refinancing or raising equity, I'll give them a closer look.
For anyone that has made it this far, I recommend listening to this recording of a recent Quest presentation at an investment conference as a counterpoint. It goes into significant detail about Quest's business model and why they believe it differentiates them.
For further details see:
Quest Resource Holding: Expensive Debt, Not Enough Growth