Description

Overview

Harsco Corporation is a $1B+ market cap company in the later innings of a transformation from an industrial conglomerate to an environmental services focused business.  The stock is at $14+ today, vs. $23+ pre-Covid, due to three things: (1) the economic impact of Covid on some end customers; (2) the temporary operational issues in one of their three segments; and (3) a seemingly high leverage ratio.  Over the next 12–18 months I expect the company will sell its last remaining industrial business in a significantly deleveraging transaction.  This will result in a pure-play environmental services company, with roughly 1.1x turns of net debt, trading at Adjusted 5.2x EBITDA and a double-digit free cash flow yield.  At a more appropriate 8–10x Adjusted EBITDA multiple on the future entity, or 5–6.5% FCF yield, HSC should appreciate to the $25-$32 range for a gain of 75–125%.

Segment Breakdown

Harsco Corporation is an industrial maintenance service company with three divisions (Environmental, Clean Earth + the recent ESOL acquisition and Rail). 

Environmental…. One of the world’s largest providers of on-site services for product quality improvement, resource recovery from steel and metals manufacturing and material logistics.  Environmental provides meltshop and furnace services that help the molten production process run smoothly.  Other services include under vessel cleaning and the cleaning and removal of split steel, ladle slag and general melt shop debris.  Services are typically part of long-term contracts (8-10 years) with 90% plus renewal rates.

Clean Earth + ESOL…  Clean Earth was acquired in June 2019 and supports customers with the processing and reuse of contaminated materials (50% of revenues), hazardous waste (40% of revenues) and dredged materials (10% of revenues).  There are 220 active permits that have a 100% renewal success rate and 27 facilities (9 treatment, storage and disposal facilities).  Clean Earth has some favorable business dynamics as it isn’t cyclical, provides inorganic growth opportunities, has high barriers to entry given the highly complex regulatory market and has 6K customers under long-term contracts.  From 2014-2018, Clean Earth grew 7% organically and 14% overall annually.   HSC closed the ESOL acquisition in April 2020 in the midst of peak Covid fears and received very favorable financing.  HSC paid 13x Adjusted EBITDA and is targeting to double Adjusted EBITDA by year 3 as ESOL was an orphaned part of Stericycle and was vastly underperforming.  ESOL operates in three primary segments… Industrial (45% of ESOL revenues) where they provide hazardous waste collection, transportation, disposal, recycling, remediation, field services and emergency response for companies across consumer products, aerospace, chemical, education, pharmaceutical and industrial companies; Retail (40% of ESOL revenues) where they provide turn-key services to manage the safe processing and disposal of hazardous waste from retail environments for companies such as Amazon, the superstores, home centers, pharmacies, groceries and e-commerce platforms; and Healthcare (15% of ESOL revenues) where services include the logistics, transfer and disposal of hazardous waste, lab packing and emerency response for hospitals, physician offices, dental practices, nursing homes and veterinarians. 

Rail… Rail is a global provider of equipment, after-market parts and services for the maintenance, repair and construction of railway track.  The drivers include global railway track maintenance-of-way capital spending, outsourcing of track maintenance and new track construction by railroads and increased focus on safety, collision avoidance and warning systems, track condition monitoring and maintenance.

Guidance/Covid

Pre-Covid 2020 Guidance called for Adjusted EBITDA of $280-$310MM.  This guidance excluded the ESOL acquisition which closed in early Q2 and on a full year basis was guided to $550MM in Revenue and $35MM of Adjusted EBITDA at the time.  Longer term guidance calls for ESOL Adjusted EBITDA to double over 3 years and for Rail Adjusted EBITDA to rise from $30MM in 2019 to ~ $100MM over 3 years given the substantial backlog.  2020 guidance was previously withdrawn due to the Covid crisis but mgmt did note the following on their Q2 call in early August… for Q3, Revenue will modestly increase vs. the Q2 level and Adjusted EBITDA will be even with or decline slightly below Q2’s $59MM due to some expense timing ($10-$12MM impact).  They remain committed to being FCF+ for the year and will be FCF+ in the 2H.  More importantly, Mgmt’s ESOL & Rail long-term (year 3) Adjusted EBITDA targets remain in place.

Environmental has been negatively impacted by Covid while the other segments have seen small to negligible impacts on their business.  The latest consensus estimates call for $241MM (~$250MM pro forma full year for ESOL) of 2020 Adjusted EBITDA.  Consensus is $315MM for 2021.

Thesis

The main components of the thesis are as follows…

      ·        The stock was hit pre-Covid due to some temporary manufacturing inefficiencies in the Rail segment during Q4 of 2019.  The rail issues have been largely fixed and after a couple quarters of execution, sentiment should rebound.

          ·     Mgmt is transforming HSC into a pure play Environmental Solutions platform which should help re-rate the multiple over time.

·        Rail will likely be sold in the next 12-18 months to a strategic.  Mgmt is focused on improving operations and dealing with Covid in the near term but has made it very clear that there is demand for the Rail assets and that they are a willing seller to further help the transformation to an Environmental Solutions platform.  My diligence checks support the mgmt claim that multiple strategics would be interested at double digit Adjusted EBITDA multiples. 

·     Significant profit improvement from ESOL and Rail.

o   ESOL was an orphaned asset under Stericyle and mgmt is very familiar with the assets.  ESOL should be able to double over the next three years as several basic profit improvement initiatives are underway across pricing, logistics and eliminating back office redundancies.  Industry contacts I spoke with thought “a well-run ESOL should have 15-20% Adjusted EBITDA margins” (implies $83-$110MM of Adjusted EBITDA) which is in-line with what mgmt thinks is more likely down the road. 

o   Rail is targeted to grow from $30MM of Adjusted EBITDA to $100MM as HSC executes on its record backlog.  Rail's backlog is at Q2 was $456MM (up 5% sequentially and up 57% yoy).  The manufacturing issues that popped up in Q4 of 2019 at the South Carolina plant have been largely fixed and the business has seen very little impact from Covid.  Several future big ticket project discussions with international and domestic players have recently percolated back up after a Covid impacted pause. 

   ·     Compelling valuation  

o   HSC is trading at 8.8x pro forma Adjusted 2020 EBITDA, 7.1x 2021 and 5.6x 2022 with FCF yields of high single digits/low double digits.  FCF yields using maintenance capex are in the low double digit to mid-teen zone.  Assuming a sale of Rail for $500MM in net proceeds (post a 20% tax rate) would lower those multiples by almost a half turn and take leverage to 1.1x.

o   SOTP Detail

§  Environmental is worth 7-8x Adjusted EBITDA.  Peers have recently been acquired in that range.

§  Clean Earth (with ESOL) is worth 10-12x Adjusted EBITDA.  For reference, HSC paid 9.6x Adjusted EBITDA for Clean Earth and 13.0x for ESOL.

§  Rail assets are worth 10-12x Adjusted EBITDA and I’ve had several diligence calls noting a belief that the segment is worth $700MM+.  There are also decent synergies to the eventual strategic buyer.

      ·    Focus on FCF

o   Mgmt is focusing the Environmental segment on EBITDA Less Capex and FCF vs. top line growth which is a substantial positive to the total HSC FCF story.  This was evidenced in Q2 as YTD FCF in Environmental was positive $32MM vs. negative $16MM last year.

Key Risks

HSC has several risks and some dynamics that can give some pause…

·         Levering up in the midst of Covid to acquire an underperforming asset is one sure fire way to make investors nervous.  That said, the deal with the banks was very favorable, there is positive FCF and liquidity of $390MM+.  Plus, the rail segment could be sold to quickly de-lever the situation.

·         Mgmt is very optimistic on the ESOL turnaround but it can clearly take longer than appreciated to right the ship. 

·         Environmental is sensitive to steel production levels which are forecasted to decline 15-20% this year before rebounding to the high single digits next year. 

·         Covid obviously creates some uncertainty and mgmt noted that “business likely bottomed in Q2, but recovery is slow and forward visibility limited”.

Summary

HSC mgmt has done a decent job of repositioning the company as an Environmental Solutions platform and the final stage will include the sale of Rail.  Covid creates uncertainty and risk for the near term but HSC has ample liquidity, a favorable maturity ladder and the backstop of de-levering with a sale of Rail.  The risk reward is compelling. 

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This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

Catalyst

ESOL profit improved 

Rail segment profit improved

Rail segment sold