2023-07-14 17:09:54 ET
Summary
- The company’s revenues have almost tripled since 2020 and TTM adjusted EBITDA stands at $16.7 million.
- Yet, rising interest rates boosted interest expenses to $2.4 million in Q1 2023 and adjusted net income slumped by 46.2% year-on-year to just $0.6 million.
- In my view, Quest Resource has a limited capacity to pay down its term loan, and the company could decide to tap the equity market soon.
- I think it could be best for risk-averse investors to avoid this stock.
Introduction
I like to write about undercovered micro-cap stocks on SA, and today I'm taking a look at Quest Resource Holding Corp. ( QRHC ). It's a waste management company that has managed to boost its annual revenues by over 50% since 2016 as well as more than double its gross profit margin thanks to acquisitions and focusing on value-added services. Yet, I think that the company's turnaround story has been getting undone over the past several months as rising interest rates are making its debt load unsustainable. The interest rate on the main loan of Quest Resource rose to 11.67% as of March 2023 compared to 7.5% a year earlier. This alone boosts interest expenses by $2.5 million per year, and my rating on the stock is neutral. Let's review.
Overview of the business and financials
Quest Resource is a Dallas-based provider of waste and recycling services focused on large companies and its customers include tire manufacturer Bridgestone Corporation ( BRDCY ), agricultural giant Archer-Daniels-Midland ( ADM ), and financial services group JPMorgan ( JPM ) among others. The company specializes in recycling and landfill diversion solutions, and it has clients in the grocery, retail, automotive, restaurant, industrial, and construction sectors among others. The average deal size is in the seven figures and Quest Resource basically acts as a broker as it contracts services from smaller local operators as subcontractors, and it gets the spread between them and national clients.
Quest Resource currently has over 100 waste streams and its subsidiaries include Quest Resource Management Group, Landfill Diversion Innovations, YouChange, Quest Vertigent Corporation, Quest Vertigent One, Quest Sustainability Services, RWS Facility Services, Sustainable Solutions Group, and Sequoia Waste Management Solutions. The group has an asset-light business model with a network of over 1,000 recycling facilities and 25,000 trucks, and it has a presence in the USA and Canada. Quest Resource has a network of some 3,500 vendors.
Looking at the financial performance of the business, the company had negative EBITDA in 2016 and a new management team decided the best way to improve profitability was to pivot to value-added services and high-margin solutions. In addition, Quest Resource has made several small acquisitions over the past few years to boost revenues and EBITDA. The focus was on regional competitors and the bulk of the deals took place in 2020 and 2021 when the company spent about $66 million on M&A. While this strategy initially resulted in a significant decrease in revenues, the long-term improvements in the financial performance of the business seem compelling as the gross profit margin more than doubled by 2018 while revenues have almost tripled compared to 2020. In addition, the adjusted EBITDA margin has been consistently over 5% since 2021 thanks to economies of scale.
Yet, we come to the red flags. You see, the acquisitions were primarily financed by debt, which wasn't an issue in a low interest rate environment. With central banks across the world hiking interest rates to combat high inflation, soaring interest expenses have been eating away at profits and net income has been in the red since Q3 2022. In my view, the situation is getting dire as interest expenses soared to $2.4 million in Q1 2023 which was equal to over 60% of the $4 million adjusted EBITDA for the period. In addition, the adjusted net income slumped by 46.2% year-on-year to just $0.6 million.
Looking at the balance sheet, the debt level hasn't changed much compared to March 2022 as net debt inched up by just 0.3% year-on-year to $59.7 million. Yet, the interest rate on the main loan of Quest Resource has soared to 11.67%.
The term loan with Monroe Capital Management Advisors accrues interest at the Secured Overnight Financing Rate (SOFR) plus a margin ranging from 5.5% and 7.5%. Considering that the SOFR has increased to 5.05% as of the time of writing, it seems that Quest Resource is in a tough spot financially.
That being said, I expect adjusted net income to remain in the black for Q2 2023 as Quest Resource has been taking steps to decrease the Monroe term loan. The company revealed in its earnings call for Q1 2023 that it paid down $5 million on this credit facility after the end of the period. This could save about $0.2 million in interest expenses in Q2 2023. Yet, I think that the rate of debt repayment is likely to slow down as operating cash flow in Q1 2023 was just $3 million. Quest Resource could refinance its debt at lower rates, but there is no indication that the company is working on such a plan. Another scenario to strengthen the balance sheet is an equity offering, but I think this would result in significant stock dilution, considering the market capitalization of Quest Resource is just $147.7 million as of the time of writing.
Turning our attention to the valuation, Quest Resource has an enterprise value of $207.4 million as of the time of writing and is trading at an LTM EV/adjusted EBITDA ratio of 12.4x. While this might seem high at first sight, I think it's a decent level considering this is a stable asset-light business with positive organic growth. That being said, I think it could be best for risk-averse investors to avoid this stock until Quest Resource refinances its debts or strengthens its balance sheet.
Investor takeaway
In my view, Quest Resource has completed a compelling turnaround of its business over the past few years, but the acquisitions carried out in 2020 and 2021 have put it in a precarious position now that we are in a high interest rate environment. I think the market valuation of the company is relatively low but opening a position now seems risky as Quest Resource has a limited capacity to pay down the Monroe term loan and the company could decide to tap the equity market to strengthen its balance sheet. I plan to keep this stock on my watchlist and wait until the debt issues are resolved.
For further details see:
Quest Resource: The Debt Situation Seems Unsustainable