Description

I recommend shorting Heritage-Crystal Clean (NDSQ:HCCI), with an initial price target of $12.50/share.

I. BUSINESS DESCRIPTION

HCCI operates in two segments. The Environmental Services segment places parts cleaning equipment at auto servicing centers, and sells customers a solvent for cleaning greasy and oily parts. The solvent is petroleum based and, like any petroleum-based solvent, is sold at a spread which stays within a general range across a commodity cycle.

HCCI has also recently completed construction on a new used motor oil re-refinery that will turn 50 million gallons per year of used motor oil into 30 million gallons of high quality Group II base oil/lube. The refinery became fully operational for the first time in 1Q12.

II. INVESTMENT THESIS/EXECUTIVE SUMMARY:

The market appears to be materially overvaluing HCCI’s recently completed used motor oil re-refinery due to unrealistic expectations for its sustainable earnings power. Assuming a generous 12x normalized EBIT multiple to HCCI’s Environmental Services business, the market is implicitly ascribing a $205 million valuation to the re-refinery, which HCCI recently constructed for just $54 million. Competition for used motor oil from a bolus of new re-refinery capacity coming online over the next 12-18 months will result in increased feedstock prices, driving down ROICs and resulting in earnings power for HCCI well below market expectations.

The overvaluation of the refinery is largely driven by the Company’s guidance, based on 1Q2010 market pricing for the plant input (used motor oil) and plant output (Group II base oil), that the refinery will generate $18m of plant-level EBIT (33.3% simple ROA). The reality is that HCCI’s new plant adds 50m gallons (~25%) to domestic used motor oil re-refinery capacity, and an additional 163m gallons (+66% post-HCCI addition) is currently under construction and due to come online before the end of 2013. In total, the re-refinery industry demand for used motor oil will increase to over 400 million gallons per year, compared to 1 billion gallons of total used motor oil available, of which just 170 million gallons has historically been available to re-refineries. The addition of new re-refinery capacity is creating an arms race for feedstock supply, which will quickly erode the return potential of re-refineries, resulting in industry ROICs equal to industry cost of capital (8%-12%), and justify balance sheet-driven valuations.

III. CAPITALIZATION

(millions except per share)

Share Price (5/7/2012):                      $20.46 
Basic Shares Outstanding:                  18.19 
Options Dilution:                                   0.31 
Fully Diluted Shares O/S:                     18.50

Market Capitalization:                        $378.0

Cash – 3/31/12:                                  $0.7 
Cash – 4/25/12 issuance:                  $53.6
NPV of NOL (at 1x BV):                       $15.2 
Total Cash & Equivalents:                  $69.5

LT Debt:                                             $22.5 

Enterprise Value:                               $331.0

IV. RE-REFINERY BUSINESS BACKGROUND AND VALUATION

A rapid increase in total re-refining capacity is driving significantly increased demand for used motor oil – the feedstock for re-refineries, and a previously undesirable waste item – which will rapidly erode the spread that re-refineries are able to earn until industry ROIC = WACC.

According to HCCI, 1.3 - 1.4 billion gallons of used motor oil are produced domestically each year. ~945 million of these gallons are collected and reused for industrial fuel purposes, and as an ingredient in asphault. Of the 945 gallons, 18% (or 170 million gallons) has historically been used as feedstock for re-refineries.

Meanwhile, existing and announced domestic re-refining capacity looks like this:

(millions of gallons of used motor oil re-refining capacity) 
                                  2011        2012E        2013E 
Safety-Kleen*            135           145            195 
Evergreen                   23            23               23 
Heartland Petroleum   20            20               20 
Universal Lubricants    20            20              20 
HCCI                             -             50               50 
FCC                              -               -                40 
Universal ES                 -               -                30 
Nexlube Tampa            -               -                28 
Greenview                    -               -                5 
TOTAL:                       198          258            411 
New addition:                             60             153 
*Note: Safety-Kleen claims to collect 200m gallons per year of used motor oil, of which they can only re-refine 135m gallons currently. The remainder is presumably sold back into the market.

There is an arms race occurring in the market right now to acquire used motor oil feedstock, because at the current market spreads, re-refinery operators are able to generate ROAs well in excess of their cost of capital. This arms race is exacerbated by capital investment in new refineries (there are more proposed projects in addition to the above projects under engineering/construction listed above), and is going to very quickly drive refinery spreads to an ROA that approximates their cost of capital (est. 8% - 12%).

For that reason, this is a business that, in my opinion, should be valued off of adjusted book value/replacement cost, plus an adjustment for excess returns earned between now and whenever industry ROAs normalize. Note that HCCI appears to be the cost leader thus far in re-refinery construction, having spent $54 million in to build 50 million gallons of used motor oil capacity, or $1.08 of CapEx per gallon. Of the projects announced above, I have been able to get capital cost and volume data for the below:

Safety-Kleen 10m gallon upgrade to existing plant: $26m, or $2.60 CapEx per gallon 
Safety-Kleen new 50m plant: Est. $74m (based on $100m of announced financing availability for re-refinery capacity expansion, less $26m for upgrade listed above): $1.48 CapEx per gallon 
FCC: $50 million for 40m gallons, $1.25/gallon 
Universal Environmental Services: $52m for 30m gallons, $1.73 CapEx per gallon 
NexLube Tampa: $80 million for 28m gallons, $2.86/gallon. (I suspect this is high because they have 12 acres of owned land in tampa, on a peninsula.) 
Greenview: $10 - $12 million for 5m gallons, $2.00 - $2.40 per gallon

Based on these comps, HCCI’s plant is worth anywhere between $63 and $143 million. In my opinion, Safety-Kleen will dictate the market – that is, keep building plants until they can only earn their cost capital. Thus (and this is admittedly more art than science), I opt to use the blended cost of Safety-Kleen’s two new plants to ascribe a value of $1.67 per million gallons of capacity to HCCI’s plant, yielding a base value for the re-refinery of $83.3 million.

In addition, so as to account for the FCF HCCI’s re-refinery could potentially generate (assuming full capacity, compared to current run-rate feed stock supply at just 56% of capacity) while the new capacity from competitors is under construction, I add a buffer of $22.7 million. I get to $22.7m using the following math:

LTM landed cost of used motor oil to HCCI: $2.09/gallon 
LTM average relevant base oil market price: ~$4.33/gallon 
(50m gallons motor oil * $2.09) – (30m gallons base oil * $4.33) = ~$25.25 million current spread available to HCCI re-refinery at full capacity

$25.25m * (1-tax rate of 40%) = $15.15m of approximate annual FCF at this spread level (which is notably above management’s stated operating spread at capacity of $18m, and  the 1Q run-rate of $8.3m based on 2/3 capacity utilization). I assume that it takes 1.5 years for the ROIC available on re-refineries to compress to the minimum ROIC required to want to build out more capacity, at which level this plant is worth nothing more than what it costs to replicate. $15.15m * 1.5 = $22.7 million.

V. PROFITABILITY OF ENVIRONMENTAL SERVICES DIVISION

I’m not going to spend a lot of time on the fundamental attractiveness (or lack thereof) of this business. Revenue growth has been fantastic for as long as data is available, driven by both branch/customer growth and commodity price increases. Profitability, however, has been poor (and cash flow worse), because this is ultimately just another run-of-the-mill, petroleum-based chemical spread business. What I will do is quantify the level of EBIT that this business should theoretically generate based on per-branch operating metrics.

                                                         2009        2010        2011         2012E        2013E 

# of Branches:                                  58.0         62.0         67.0           72.0            77.0 

Segment Contribution (Excl D&A):    $24.8       $30.2       $28.7        $32.3           $34.5 
Contribution Per Branch:                  $0.43       $0.49       $0.43        $0.45           $0.45 

SG&A (excl D&A):                              $15.7       $17.4       $20.1        $21.6           $23.1 
SG&ADA Per Branch:                         $0.27       $0.28       $0.30        $0.30           $0.30 

Segment EBITDA:                             $9.1         $12.8        $8.6         $10.7            $11.4 

D&A                                                  $3.6         $3.90        $4.2         $4.5              $4.8 
D&A per branch                                $0.06      $0.06        $0.06       $0.06            $0.06 

Normalized Segment EBIT:               $5.5        $8.9          $4.4         $6.1               $6.6

Assuming this business is worth 12x EBIT (>2x the price at which I personally would even consider getting long this business, but that’s neither here nor there…), it will be worth $78.7 million in 2013.

*Note that this my application idea. Since I originally wrote it, 1Q results have come out showing $23m+ of run-rate SG&A for 2012, and skinnier contribution margins from ES. This is a business that the market will never really let generate significant cash flow, so I feel that I’m being exceptionally generous at the stated valuation.

VI. VALUATION/PUTTING IT ALTOGETHER

(millions except per share)

Re-Refinery @ Replacement Cost:                $83.3 
Re-Refinery Interm Cash Flows:                   $22.7 
Environmental Services @ 12x 2013E EBIT: $78.7 
Total Value of Operations:                           $184.77

Add cash: $54.3 million 
Add NPV of NOL (@1x book):                       $15.2 
Less LT Debt:                                               $22.5 
Total Equity Value:                                       $231.8

FD Shares Outstanding:                               18.5

Implied Equity Value per share:                  $12.53
Downside:                                                  (38.7%)

Catalyst