Description

Executive Summary

We were in the process of posting Heritage-Crystal Clean (“HCCI”) as a long-term compounder until the company announced yesterday evening that it agreed to be purchased by J.F. Lehman for $45.50/per share. We believe the offer is insufficient given the company’s future growth prospects, structural improvements in one of its more volatile divisions, potential for operational enhancement and strategic portfolio optionality, which imply a medium-term value per share in the mid $60’s. The stock is currently trading $0.50 through the deal price, indicating that the market agrees. 

We model an IRR in the low 20’s % range to the sponsor, indicating room for a higher offer. Given the odd collection of assets (more below), an optimal outcome could be a sale of the company’s two divisions to different strategic buyers, who can realize meaningful synergies in disposal costs and overhead. 

The acquisition requires 75% shareholder approval – an extremely high threshold (the company’s largest shareholder and its CEO own ~29% and have voted in favor) - with a go-shop expiring August 23rd. Given the low premium and minimal likelihood that the deal breaks (financing markets have reopened, no apparent antitrust issues), owning HCCI offers an attractive risk/reward in the event of a bump in price from another private equity firm or a strategic buyer.  

(See Circor as a recent example of a small cap, industrial bidding war between PE firms – KKR initially bid $49 but ultimately had to bump due to $56 due a competing offer from Arcline).

Business Overview

HCCI provides a variety of environmental services including waste collection and disposal and recycling services for industrial customers. HCCI operates two business segments: 

Environmental Services or “ES” (70% of 2023e pre-corp EBITDA)

ES provides various environmental services for small and mid-sized industrial and transportation-oriented businesses through a hub and spoke model. Key services provided include:

• Parts Cleaning (30% of segment revenue): Provides equipment and recurring solvents to clean oil, grease, dirt and sediment off parts & tools generated during production.

• Containerized Waste Disposal (20% of segment revenue): Collects and disposes of hazardous and non-hazardous waste including paint, oil filters, light tubes, batteries, etc. 

• Vacuum Services & Wastewater treatment (19% of segment revenue): Removes mixtures of oil/water sediment from pits/separators at customer facilities, to be treated at owned wastewater plants.  

• Industrial & Field Services: (9% of segment revenue, 3-year average): 

  • Field: episodic services including oil spill cleanup, soil remediation, cleaning of storage tanks, etc.

  • Industrial: planned cleaning services associated with plant maintenance and shutdowns, such as hydro blasting, steam cleaning, etc. 

• Antifreeze Collection (7% of segment revenue): collects used antifreeze and recycles it in owned facilities, to be sold to vehicle customers

ES services 95k customer locations with 645k services performed annually including 276k parts cleaning services. They are the #2 parts cleaner in US (20-25% share) and compete primarily with Clean Harbors/Safety Kleen (50% share).

ES’ customers are industrial businesses (distribution, manufacturing, etc.) as well as transportation related business (car dealers, repair shops, etc.) 

Oil Business or “OB” (30% of 2023e pre-corp EBITDA)

The OB business Collects and “re-refines” used motor oil. Re-refining is a process that cleans the oil (removes water, additives and other contaminants) for re-use in an endless cycle. The oil is collected primarily from ES customers (it cannot be disposed of in sewer or landfill) and is refined at the company’s facility in Indiana into recycled Group II base oil for use in lubricant manufacturing. OB’s end customers are primarily 2nd tier lubricant manufacturers that compete with Exxon, Pennzoil, etc. OB’s plant currently has 75m tons of capacity. 

OB is the second largest oil refiner (20% share) after Safety-Kleen/Clean Harbors (55% share). 

Key Thesis Points

High-Quality Core Business 

HCCI's primary business - the ES segment - is an attractive asset. It is a contractual, recurring revenue business providing an essential and highly regulated service. Performing in-house would be burdensome and subject business to potential regulatory infractions. The business is highly diversified, with no customer concentration and little industry concentration. As a route-based business, barriers to entry are high as density is required to be profitable. Finally, ES' services comprise a small portion of their customers' budget ($100's per month), leading to strong pricing power (mid-single-digit annually) and little incentive to switch. Dollar retention within ES is in the high 90s %. 

Strong Balance Sheet with Long-Tail of M&A Potential

HCCI is modestly levered (~0.5x pro-forma LTM EBITDA) with a stable, cash generative business model and a fragmented industry ripe for consolidation. As a route business, acquisitions in local markets can be very accretive due to substantial synergy potential while generating enhanced market/pricing power. We view this strategy as an attractive use of capital. We expect management to continue to pursue acquisitions to increase its exposure in the West (currently underearning due to subscale operations), densify existing markets, augment existing service capabilities and internalize more of its waste disposal, which should enhance margins. 

Further Growth Potential via Expanded Service Scope and Cross-Selling

In addition to growth through M&A, HCCI plans to grow wallet share with its customers by better cross-selling its products, leading to more of a one-stop-shop offering. The company's anchor product line is parts cleaning, but the average customer buys two to three services, with oil collection and containerized waste removal being the most common. Only 2/3rds of branches currently offer "vacuum services" while even fewer offer antifreeze collection. The company continues to invest to add capabilities while also adding sales managers who are incented to cross-sell. These revenues should come at higher incremental margins given route density effects. 

PFAS / Battery Collection Call Options

HCCI should benefit in future years from two growth initiatives not currently reflected in street (or our) estimates - PFAS and electric battery collection – which we treat as free optionality/upside.

• PFAS: Per- and polyfluoroalkyl or “PFAS” are commonly used chemicals in industrial and consumer products applications. PFAS are known as “forever chemicals” that tend to accumulate in the environment and in the human body, which can be harmful in large quantities. The dangers of PFAS are becoming more widely known (especially due to several large-scale lawsuits), with many states passing various forms of legislation to regulate them. It is expected that the EPA will introduce federal legislation later this year or in early 2024. There are various competing methods for eradicating PFAS with differing efficacies – given the nascent market, no individual process has become the standard. HCCI has entered into several exclusive, capital-light partnerships that will allow it to service and process what it believes is the most efficient means for capturing and eradicating PFAS, beginning this year. Management has noted that operators are not waiting for more formal legislation and management notes their phones are “ringing off the hook”. A list of current projects can be found in the company’s recent investor deck. Primary customers are industrial businesses and landfills. Management believes this is a “nine figure” opportunity over time with comparable margins to its core business. $25m of revenue expected in 2023 growing to $70m in 2027. At segment level margins, this would be 20% accretive to EBITDA over time.

• Electric battery JV: A more difficult to quantify opportunity is HCCI’s plan to utilize its collection network to collect spent electric batteries from cars. This would be an incremental revenue opportunity and also act to offset potential EV headwinds to the core business. HCCI has a partnership with (and investment in) Cirba Solutions to pilot picking up depleted lithium batteries (utilizing existing infrastructure) in several cities. Cirba processes and recycles the batteries while HCCI is responsible for the collection. Note, Cirba recently secured $200m in financing from private equity firm EQT. Cirba is majority owned by The Heritage Group, which co-founded HCCI and is its largest shareholder. 

Volatile Oil Business Masking Value but Structurally Improving

HCCI's OB business is akin to a refinery, with year‐to‐year revenue and margins that are extremely difficult to predict, with an EBITDA range of $0m-$100m through a cycle. The business is also highly niche, with limited end price information and/or ability to hedge. Additionally, the business is operating at capacity, meaning there is little prospect for volume growth. 

However, there are structural changes happening in the market that could improve the quality of the business. IMO 2020 is a new regulation that limits the amount of higher sulfur fuels that can be used in marine applications. This has reduced demand for the feedstock used in the OB business (i.e., lowering COGS). Additionally, while re-refined fuel has historically sold at a discount to "virgin" (due to slightly inferior performance characteristics), demand for "greener" inputs could improve over time, lessening this discount. Together, these changes could tighten the range and potentially the volatility of the business' earnings, leading to a higher value for the segment.

Value Creation Optionality via Break-Up/Sale

HCCI is a logical break-up candidate. Its two businesses are vastly different, with varying degrees of volatility, pricing power and growth prospects. Packaging these businesses together results in a highly confusing story, as the ES business is relatively straight forward while the OB business is complex, opaque and in a niche market with limited available industry data. The OB business requires significant mindshare that is disproportionate to its de minimis contribution to total value (as evidenced by the amount of time/questions it receives on earnings calls). This dynamic weighs on valuation as HCCI trades in-line with oil refiners. Once the OB business generates more stable (and structurally higher) earnings as discussed above, HCCI could look to sell the refining assets (potentially to a large, base II oil producer such as Exxon), while maintaining the collections operations and setting up a long-term tolling agreement with any potential buyer. The standalone environmental services business could eventually become an acquisition target by a larger waste collection/management firm. 

Further Upside from Operational Enhancements

HCCI is on the cusp of implementing various operational improvements which have yet to be reflected in its P&L. In short, the company is currently run with antiquated tools and is in the process of adopting more modern technology to achieve efficiencies throughout the organization. Notable initiatives include:

• Reducing branch network costs: potential to move directly from branch to waste treatment over time – with no intermediate hub step - as more processing is internalized, eliminating four hubs in total. This could result in ~$10m of cost reduction per management. 

• Improving route density: potential to improve route/driver utilization with better planning tools (handhelds, etc.), which historically has not been a focus of the company.

• Improving refinery operations: HCCI has implemented “mechanical integrity” and “spare parts” programs in 2019, considerably improving operations, but unplanned downtimes arise periodically and further room for improvement exists.  

• Reducing HQ costs: $60m of unallocated overhead appears excessive and is a function of suboptimal operations. The company has no electronic inventory tracking, highly manual A/R and A/P processes but is currently upgrading ERP to NetSuite and upgrading FP&A software to modernize this, the benefits of which should show up over time. 

Additionally, ES segment EBIT margins have recently been in the low 20% range compared to previous levels of ~30%. Management cites drop due to investment in added selling resources, building out underpenetrated regions (west coast) and temporal supply chain pressures post COVID. Over time, margins should revert to historical levels. 

Emerging ESG story

HCCI has attractive ESG attributes. The ES segment treats 50m gallons of wastewater, recycles millions of gallons of antifreeze, recycles used parts cleaning solvent and offers proprietary, environmentally friendly aqueous parts cleaning solutions. The OB business recycles/sells spent oil, providing an alternative to "virgin" oil-based inputs. Over time, additional substances may be deemed hazardous/subject to more stringent disposal rules (example: PFAS), which could create additional revenue opportunities. These "green" elements could also lead to improved economics as end consumers demand cleaner products. As investors increasingly seek ESG opportunities, HCCI could garner a valuation benefit, which it is not currently receiving.

Valuation & Returns

Given the company’s disparate businesses, we value HCCI on a sum-of-the-parts basis, using 2026 estimates (3 years out). We apply a 20% discount to waste peers to arrive at a 12x multiple for the ES business while conservatively valuing the OB business at replacement cost. This blends to an ~11x EBITDA multiple, in-line with direct peer Clean Harbors. This results in a mid-$60’s stock price at the mid-point or a ~13% IRR from the J.F. Lehman bid price. Note, our estimates include no benefit from the PFAS and battery collection opportunities or any operational improvements, which would be additive to returns.

Risks

1. Exposed to declining oil usage/rising EV usage

   1. 12% of ES business is tied to auto-related customers that could see volume declines as EV gain penetration

   2. OB segment almost entirely reliant on used motor fuel 

   3. Interesting avenues to reposition business with opportunities such as PFAS, battery JVs and field services

2. Price increases fueling large portion of revenue growth

   1. Reduction in repair shop bays and centralization of auto maintenance has weighed on parts cleaning over the past decade

   2. Price has driven a large portion of ES growth which could eventually become more difficult to rely upon

3. Long-term environmental/contamination risks

   1. As with any waste business, HCCI could incur significant financial costs from accidents, non-compliant handling, etc. of materials during transportation or disposal

   2. Dominant, vertically integrated competitor 

4. HCCI’s primary competitor is Safety-Kleen (a division of public company Clean Harbors), which owns most of its own disposal assets (HCCI does not)

Catalyst

Bidding war/price bump