Description

I am recommending the short sale of American Ecology Corporation (ECOL), a $319mm market cap company that provides radioactive, hazardous and industrial waste management services to commercial entities such as nuclear power plants, medical and academic institutions, steel mills, refineries and chemical production facilities. See www.americanecology.com for the Company’s SEC filings and investor presentations. In a nutshell, the stock popped a few months ago based on the announcement of a very large disposal contract with Honeywell (the “HON Contract”). It is currently trading near an all-time high and is grossly overvalued based on a misunderstanding of the impact of this large contract on the Company. Further evidence of the market’s mispricing of what has heretofore been a small, niche disposal company comes in the form of very heavy insider selling following the stock’s sharp move higher on news of the HON Contract. As the market realizes the true impact of this deal on ECOL, it should reprice the shares significantly lower.

First, some basic facts. I will not repeat the detailed description of the Company readily available on its website. ECOL’s four principal assets are the following disposal facilities: (i) Grand View, Idaho, a 1304-acre ECOL-owned site 60 miles SE of Boise which accepts hazardous waste, PCBs and certain NRC-exempt (naturally occurring) radioactive and mixed wastes (including electric arc furnace dust from steel mills such as Nucor); (ii) Robstown, Texas, a 240-acre ECOL-owned site near Corpus Christi which accepts hazwate and non-hazardous industrial wastes; (iii) Beatty, Nevada a 80-acre leased site (lease with State of Nevada expire 2007) in the Nevada desert east of Death Valley, which accepts hazwaste; and (iv) Richmond, Washington, a 100-acre leased site on the DOE Hanford Site, which accepts low-level radioactive waste (LLRW) only from 11 western states pursuant to rates set by the Washington Utilities Commission. Think of this as a specialized landfill business where hazwaste streams are treated and disposed.

The hazwaste business is a mature, competitive business, essentially a specialized niche subset of the much larger waste disposal market. Indeed, the larger waste industry players such as Waste Management have small operations for so-called special wastes buried within their larger organizations, and there are other niche players that compete with ECOL as well, including Envirocare of Utah, which was sold in the past year or two to an LBO firm (more on that later). The business has two drivers. The first, which the Company calls “base business”, is relatively more steady, is a reasonably consistent stream of industrial wastes such as wastes from chemical plants and refineries and electric arc furnace dust from steel mills (e.g., Nucor, a top 3 customer of ECOL for some time and its largest base business customer). The second driver, which is considerably lumpier and less predictable, is remediation projects such as cleanups mandated by CERCLA and other environmental regulations. An example of the latter type of work is a $10mm project in 2003 (about 18% of 2003 revenues) for Shaw Environmental and Infrastructure that involved the cleanup of a contaminated site in New Jersey (and was funded by the State). The HON Contract is another example of this type of work, but more on that later.

Since 2001, ECOL’s revenues have fluctuated between $40mm in 2001 and a high of $57mm in 2003, with EBITDA during that timeframe running from a low of $7.2mm in 2001 to a high of $19.1mm in 2004 on revenue of $54mm (35% margin). Due to the project nature of much of the business, revenues and margins can be quite volatile from period to period. I have set forth below my estimate for 2005 operating results based on results YTD and management guidance (all figures in millions) followed by a current valuation snapshot. Please note that valuations in this industry are generally driven by EBITDA multiples, which is my focus herein (and in any event, ECOL’s EPS has historically had significant noise in it).

Revenues $65
EBITDA $21.9
EBIT $15.1

Shares Out 17.6
Price (10/5) $18.09
Market Cap $319
Net Debt $(21)
EV $298
EV/EBITDA 13.6x

ECOL has been in business for some 50 years and has been a little noticed microcap stock since it went public out of Teledyne in 1983. After several ill-fated expansion attempts in the 1990s, which generated lots of write-offs, litigation and squandered capital, a new management team was brought in in 2001. To their credit, the new team cleaned up ECOL (pardon the pun) and refocused it on its core hazwaste disposal business. The stock generally bounced around between $2 and $5 between 2001 and 2003 before nearly doubling in 2004 to almost $12 on the back of a simpler, more focused story and a 14% yoy increase in EBITDA. The stock was stuck between $11 and $12 through May of this year, which represented over 10x trailing EBITDA. Although I would argue that ECOL was overvalued at that time (and perhaps significantly so), subsequent events created a more compelling short.

The real short opportunity arose when the stock popped approximately 50% on news of the HON Contract in June. It has since traded as high as $19.66. This reaction took ECOL from overvalued to grossly overvalued and poised for a significant retrenchment when the market realizes the reality of the HON Contract. The HON Contract is for the transportation and disposal of one million tons of contaminated soils (chromite ore) from a site in Jersey City (yes, another NJ site, playing right into the stereotype). As described in the June 10Q: “the Company estimates revenue in the range of $175 to $240 million over a 4 to 5 year period. A significant portion of the revenue under the contract will include transportation services. As a result, management expects that while revenue dollars will increase, the Company’s gross margin relative to revenue will decrease.”

Well, what exactly does that mean? Management has been vague, but on the 2d quarter conference call pointed to the 2003 Shaw contract as directionally representative of the impact/margins on the HON Contract, adding that the HON Contract, like the Shaw contract, also was bundled, i.e. includes disposal at the Idaho facility and transportation from NJ, with the latter representing approximately two-thirds of the value of both contracts. Now, management didn’t exactly spell out the economics of the 2003 Shaw contract either, but there is enough prior disclosure to discern its margin structure and thus to provide a view on the likely impact of the HON Contract.

The Shaw contract was for approximately $10mm and was discharged in the second half of 2003 (parenthetically, this contract essentially represented all of the yoy revenue increase in 2003). ECOL gross margins on a consolidated basis have fluctuated between 41% and 46% in recent years. In 2003, ECOL’s first half gross margin (without the Shaw contract) was 43% while it dipped to 37% in the second half when the Shaw contract represented about one-third of revenues. Indeed, the gross margin on the incremental revenue from first to second half, almost all of which was Shaw, was only 27%--this in a business with clear operating leverage (i.e. incremental disposal tonnage/revenue is significantly more profitable than the overall average). The reason is simple: some two-thirds of the Shaw revenues (and the HON Contract revenues) are for transportation, which the Company has chosen to bundle with its disposal. Because ECOL does not provide all the transportation itself (it may have railcars etc, but the waste is trucked to rail, railed to ECOL’s Idaho transfer station and then trucked to the disposal site) and because sophisticated counterparties such as Shaw and Honeywell can separately price transportation, it is reasonable to believe that ECOL makes little or no margin on the transportation costs, which are largely a pass-through. I estimate (and all the disclosures support) that the Shaw deal was comprised of about $6.5mm of transport at say a 10% gross margin (or lower) and $3.5mm of treatment/disposal at an incremental margin of 50-60%, which generates a blended gross margin of approximately 25% (or about $2.5mm on the $10mm contract). Now this $2.5mm of contribution is before any incremental indirect/SG&A costs, which I assume are modest (though likely not zero), and does not account for any incremental capex (more on this later—this is a capital-intensive business).

Using the Shaw contract as a guidepost and slightly above the midpoint of management’s revenue guidance for the HON Contract implies that the total HON Contract is worth $210mm of revenues with an approximate gross profit of $53mm (25%), which is before any other incremental costs and before at least $12mm of incremental upfront capex identified by management. So a one-off contract worth less than $30mm on a PV basis generated approximately $100mm of increased market value for ECOL. Obviously, this doesn’t make any sense.

[As an aside, the market’s reaction to the HON Contract would be more justifiable if one could assume that this profit stream continued indefinitely, but even under those circumstances ECOL remains overvalued. To wit, let’s assume ECOL grows EBITDA (excluding the impact of the HON Contract) in 2006 by 10% to approximately $24mm, a respectable growth rate in a mature business and by no means a slam dunk given the Company’s erratic track record. Now add a further $10mm from the HON Contract and ECOL is trading at nearly 9x 2006 EBITDA. This is really beside the point since there is no evidence this level of cash flow can be sustained.]

A business like ECOL should trade at a discount to larger integrated waste companies (which have generally traded at 6.5-8.5x trailing EBITDA) given: the relatively smaller size of the Company and the market it addresses, the volatility of cash flows due to the project nature of the business, its significant customer concentration (US Army Corps of Engineers is ~30% of revenues), the higher risk associated with its business (political, regulatory, environmental, operating etc—witness the fire at its Texas facility a few years ago), its much smaller asset base, the illiquidity of the stock, and the Company’s own mixed track record. Moreover, a competitor of ECOL called Envirocare of Utah was sold to the LBO firm Lindsay Goldberg 18 months ago or so, reportedly at a very modest multiple (I heard less than 6x EBITDA), which is in part due to the inability to leverage these businesses significantly to enhance equity returns, which stands in stark contrast to the more traditional waste companies that generate relatively steady cash flows that are readily and prudently leveraged.

A close look at the assets of this business also militates in favor of a modest multiple. These sites, like any disposal facility, have limited lives and become liabilities over time as the costs of closure and post-closure care approach. Moreover, closure/post-closure liabilities generally must be secured through some third party financial assurance such as LCs or surety bonds, which is another reason assets like ECOL’s are difficult to leverage. A final indicia of asset value lies in ECOL’s own purchase of the stock of the entity owning the Idaho site in 2001 for a grand total of $1mm. I concede that was a great deal and management’s done very well with the asset, but it is directionally indicative of the limited value of these assets.

The catalysts I expect to drive the stock lower are the combination of results that disappoint due to unrealistic expectations for the HON Contract together with continued heavy insider selling. Two directors who collectively owned 6.1mm shares (about 35% of total shares outstanding) registered such shares for sale shortly after the HON Contract was announced. They have since disposed of 1.5mm of these shares at $18.50 so there remains a significant overhang from selling shareholders. Though somewhat speculative, I also assume that rising interest rates and bursting of the real estate bubble also will depress ECOL’s business as demand to develop marginal sites (such as NJ brownfields) will diminish. Finally, my analysis above assumes flawless execution of the largest contract in ECOL’s history, which will increase volumes dramatically, so there is also meaningful execution risk for ECOL. I believe the principal risk to the short position is the announcement of another large contract.

Catalyst

Disappointing results relative to expectations
Continued insider selling