Description

Redishred is a leading provider of document destruction services to small and medium sized businesses in the United States.  The business has grown revenues at an impressive rate both organically and through acquisitions; over the last 6 years overall revenues have grown at a 30% CAGR, and organic shredding SSS have averaged 9% over this same period.  More importantly, the document destruction market is extremely fragmented, thus providing the company with a very long runway to grow at similarly strong rates for the foreseeable future.  Despite the company’s significant historical growth and strong prospects for future growth, shares trade for only 6.2x FCF and 4.9x EV/EBITDA.

I believe the company is worth around $1.15 per share, which is around 3x the current share price and would put the valuation at 11x EV/EBITDA and 18x FCF.  Shares actually traded at $1.08 as recently as November 2019 -- only 7 months ago -- and have declined for essentially two reasons since IMO (a sharp fall in recycled paper prices and COVID-19), both of which have temporarily impacted the business but are currently in the process of reversing and returning to normal.  

As the business rebounds, I expect investors will be drawn to the extremely low valuation and high quality of the business -- consistently strong organic growth, recurring revenues, extremely low customer attrition, recession resistant, high barriers to entry, highly fragmented market, no customer concentration, significant acquisition growth at low valuations, etc -- which should in turn drive a significant revaluation of the company.

Shares trades as KUT on the TSX Venture Exchange in Canada and as RDCPF on OTC Markets in the US.

Overview

Redishred’s sole operating business is PROSHRED -- a document destruction company currently operating in over 40 different markets in 21 US states.  The business is very straightfoward: they drive trucks that have been outfitted with paper shredding equipment to small and medium sized business sites, pick up bins of used paper, securely shred that paper right on site, and finally recycle the shredded waste (it can be sold as it’s used in the production of facial and bathroom tissue).  They also offer ancillary services like hard drive destruction, electronic waste recycling, physical product destruction, document scanning, etc.

PROSHRED is technically a franchise system, but as the company has been acquiring its franchisees over the last few years, the main driver of cash flows has increasingly become the company-owned operations.  The franchise system has roughly $45 M USD in system wide sales, with roughly half of that company owned, and half franchised. This works out to only around 10-12% of EBITDA coming from franchising, depending on exactly how you allocate expenses.  Although the company still actively solicits franchise partners to open up new geographic markets for them, I do think that the business makes more sense in the company-owned model, and so it is highly likely that the % of EBITDA coming from franchising will continue to decline.  As a result, I’m not going to go into much detail on the franchise operations in this report, but you can certainly find a lot of information on this in the company’s financial filings.

On that note, I want to point out that the company has extremely detailed and thorough financial reports going back many years that slice-and-dice the financial results in every way imaginable.  It’s really quite staggering how much data they provide investors on a quarterly basis, and I can’t recall ever seeing a company with this much detailed disclosure -- certainly not for a company of this size.  The sheer volume is almost a bit overwhelming, but as an analyst trying to understand the business I think you will find it particularly helpful.

Document Destruction Industry

Document destruction is a $3.6 billion market in the US -- there are a couple of larger players with the rest of the market extremely fragmented.  Iron Mountain has around 25% market share, but they are focused on larger enterprises vs PROSHRED’s small and medium sized business focus.  Shred It (acquired by Stericycle) in 2015 has around 20% market share and historically has also focused on SMEs.  With around $45 million in system wide sales, PROSHRED has a bit over 1% market share.  The remaining 55% of the market is either independents or unvended.  Around 30% of the market is served by 750+ independent operators, 90% of which have only 2 trucks or less; these are extremely small businesses with on average less than $500k in revenues.  The remaining 25% is unvended; these are companies that are shredding their paper in-house.

I think many investors have a negative perception of the document destruction industry that is unwarranted.  Businessweek, of course, famously predicted the “paperless office” in 1975 -- now 45 years ago.  While there have been declines in office paper usage over time, most offices are still awash in paper, and I think that is unlikely to change for the foreseeable future.  More importantly, the document destruction industry is not really driven by office paper usage per se, but by recycled office paper.  While overall office paper use has generally declined over time, this has been completely offset by an increasing percentage of office paper being recycled; the data I’ve seen in the past has shown modest increases in recycled office paper over time, not decreases.

Furthermore, the industry has certainly benefited from the increased demands for privacy protections and general concerns around information security.  As a result, not only has increased recycling rates driven the document destruction industry, but more and more of that recycled paper is being securely destroyed, often right on-site.  Finally, there has been a general trend over time of the unvended market increasingly outsourcing their document destruction which has also added to the growth rate of the vended market -- where PROSHRED operates.

PROSHRED -- A Very High Quality Business

PROSHRED is a wonderful business with consistent growth, highly predictable cash flows, and strong competitive advantages.  It possesses almost all of the qualities I look for in a business:

• Highly recurring revenues.  Over 50% of revenues are derived from scheduled shredding services.  This is essentially monthly recurring revenues (MRR) where they are receiving ~$100 per customer per month to pick up and shred paper on-site.  Although the other 45%+ of revenues isn’t scheduled, it’s still largely recurring, just not on a monthly basis.  Companies generally require the same number of purges / unscheduled pickups from year to year, such as once a quarter.  Similarly, the sales of recycled paper are a direct function of the amount of paper picked up and as a result tend to be very consistent from quarter to quarter.
  

• Virtually no customer churn.  The company has said that their annual attrition rate is only ~2%, which would seemingly imply that they almost never lose a customer for a reason other than business failure.
  

• No customer concentration.  The company doesn’t disclose any data on this, but given the nature of the business and the SME focus it’s highly unlikely that there are any customers responsible for more than 1% of revenues.

• Geographic diversification.  This is a very local business, with each market subject to its own dynamics and competitors.  As a result, the 40 different markets in the US that the company operates in provide substantial geographic diversification to further minimize risks; issues in any one locale have no direct impact on the others.
  

• Recession resistant.  The company’s customer base generally skews towards recession resistant industries.  Around 20% is healthcare, 15-17% financial services, 15% professional services, 10% government services, and the rest is diverse.  More importantly, the company is providing a fairly critical service at a low price -- paper shredding is not a big line item in anyone’s budget.  During tough times, almost no business is willing to risk compromising their information security to try to save $100 a month.
  

• Strong network effects.  The business benefits from strong barriers to entry in the form of local market network effects that generate local economies of scale.  Profitability is a function of route density, and so it is difficult for new entrants or smaller competitors to be as competitive on price as larger operators like PROSHED.  This is also the reason to expect continued consolidation in the industry.

• Highly fragmented market.  I believe that one of the main reasons why PROSHRED has been able to maintain consistently high rates of organic growth is a direct consequence of how fragmented the market is.  A significant portion of just about any document destruction market in the US is controlled by very small (sub $500k in revenues), relatively unsophisticated businesses (i.e. “a few guys and a truck”).  This dynamic allows larger, more sophisticated entities like PROSHED to gain market share over time by implementing more effective marketing strategies, offering better service levels, more efficiently planning routes, and consequently being able to be more competitive on pricing.  I expect this trend to continue.

Consistently Strong Revenue Growth

Redishred has grown revenues at a 30% CAGR over the last 6 years, with at least 23% revenue growth every year.  Revenue growth by year:

2019 ----- 53% growth

2018 ----- 23%

2017 ----- 24%

2016 ----- 25%

2015 ----- 24%

2014 ----- 32%

This revenue growth has been a function of both acquisitions and strong organic growth.  It is also affected by: changes in the USD/CAD exchange rate (the business operates in the US but the company reports financials in CAD) and changes in recycled paper prices (which can be volatile).  As a result, I like to evaluate organic growth by specifically looking at company-operated “same store sales” shredding revenues in USD -- which is one of the many metrics that the company provides on a quarterly basis.  This eliminates the impact of fluctuations caused by acquisitions, exchange rates, and paper prices.  

Using this metric, revenues have grown organically at a 9% CAGR over the last 6 years, with at least 5% growth every year.  Organic revenue growth by year:

2019 ----- 6% organic growth

2018 ----- 9%

2017 ----- 12%

2016 ----- 13%

2015 ----- 5%

2014 ----- 7%

Acquisition Model

Over the last 6 years the company has augmented its high rates of organic growth with a number of acquisitions.  I think Redishred’s acquisition growth is particularly valuable because they have a built-in deal pipeline from their franchise network, which is where the vast majority of their acquired revenues have come from.  Generally speaking, as franchise agreements have been coming up for renewal they have been providing their franchisees that are looking to retire with an exit and acquiring them.  It can obviously vary depending on the market, but these are generally businesses with ~$2 M in revenues and they have been willing to pay 5.0 - 6.5x EBITDA depending on the quality of the business.  With 50% of the system wide sales still in the hands of franchisees, acquiring these businesses alone has the potential to double Redishred’s revenues in the coming years.

They also actively pursue smaller, tuck-in type acquisitions in markets where they already operate.  These understandably can be purchased at much lower valuations at more asset-based prices; these generally have under $1 M in revenues, a couple trucks, and they might pay anything from just the asset value of the trucks to 4x EBITDA.  While the company has been much more active with the larger franchisee acquisitions in the last year, considering the short-term impacts of the pandemic I think there could be an increase in distressed opportunities for Redishred to pursue.

Temporary Headwinds -- Paper Prices and COVID-19

Seven months ago shares were trading at $1.08 per share and have since declined to $0.39 per share despite strong operating results -- so what happened?  Recycled paper prices fell precipitously and then COVID-19 hit, both serving to create short-term headwinds that I believe are now reversing and returning to normal.

As previously mentioned, the company sells the recycled shredded paper (SOP -- sorted office paper) that it recovers from its customers, and the price of that paper can be very volatile.  Although it’s not a large percentage of revenues, because these sales are essentially pure profit, fluctuations in the price are particularly impactful to EBITDA.  At the end of 2018 the average price received per ton was around $185.  Those prices plummeted throughout 2019, and reached down to $67 per ton in Q4 and Q1 2020.  The 10-year average, however, is around $135 per ton -- essentially double the recent price levels.

I believe that the business should be evaluated using the average long-term paper price of around $135.  This headwind has actually in fact already reversed (with the 2nd headwind certainly a major driver of this).  Document destruction companies are the primary suppliers of SOP, and with shredding volumes down, supply has become constrained.  SOP prices spiked as high as $175-180 in May, and they have settled back to around $150 per ton the last I saw in late May/early June.

The second headwind to hit the stock was obviously COVID-19.  The demand for document destruction is particularly impacted by the sudden closure of offices -- but not really IMO by the medium or longer-term impacts of this pandemic.  The company has said that the impact peaked during the first three weeks of April, the declines started to flatten out in late April/early May, and the business started to rebound during the 2nd half of May as offices began to open up again.  April revenues were estimated to be down around 40%, which actually was better than they feared earlier in the pandemic.  As offices continue to re-open across the US, I expect that the rebound they’ve indicated for May will continue and for revenues to eventually return to prior levels.

I think that the market broadly understands that these office closures are a purely temporary headwind that will continue to reverse.  As a smaller sized company, however, Redishred has simply been orphaned in the market and its current valuation suggests that emotions have dominated over a rigorous analysis of the facts.  I think it’s instructive to look at how the market has reacted with the company’s closest publicly traded competitor, Stericycle.  Shred-It has a very similar customer profile to PROSHRED, and is probably ~30% of Stericycle’s EBITDA.  Stericycle also reported 40% declines in their document destruction revenues. At the peak of the pandemic fears, Stericycle’s share price declined ~30-35%.  But as investors began to understand the temporary nature of these closures and could see a pathway to them reopening, Stericycle recovered 100% of its decline and returned to its prior price level pre-pandemic.  As “2nd wave” fears have hit the market, shares are off a bit once again, but much less so far -- about 10% off pre-pandemic levels.  In contrast, despite SOP prices spiking and a strong Q1 report, Redishred is barely even a third of the share price it hit only seven months ago and has at no point seen any bounce in share price whatsoever.

Finally, to the extent that there are any changes whatsoever to office paper use as a result of the pandemic, I expect any such changes to be minor and offset by other factors.  

First of all, the company is obviously being proactive here and introducing programs that will help employers to ensure that their work-from-home employees continue to securely destroy documents.  When offices are forced to suddenly close, companies understandably are going to just put a pause on their document destruction and cancel their scheduled appointments; commerce is still happening, however, and the need for information security has not gone away.  To the extent that some employers might have more employees working from home more often, they are going to still need documents to be destroyed securely whether that work is being done in an office or at home.  Paper shredders like Redishred are in a position to support these sorts of employees as well without any material change to how they operate, so long as employees bring bags/boxes of their paper to be destroyed back to the office for pickup.  I would note that the sorts of employees that are dealing with large volumes of sensitive documents are specifically the sorts of employees that are least likely to be allowed to work from home in future for obvious privacy/security reasons.  PROSHRED’s SME focus should also insulate it somewhat from any such work-from-home trend as to the extent that this is a phenomenon it appears to be much more of a large enterprise one right now.

Secondly, to the extent that paper volumes do decline industry-wide for whatever reason, I believe that you’ll see paper shredders implement price increases and/or surcharges to offset these losses.  Any such volume impacts will affect everyone in the industry equally, the paper shredders will still need to earn an acceptable return on their assets (largely shredding trucks), and push-back from SMEs is unlikely given the low cost / critical nature of the service.  This sort of a phenomenon has already played out in many markets in the past when paper prices fall and many shredders start to implement “paper surcharges.”

Thirdly, to the extent that paper volumes decline, I think you’ll see any such impact be offset by marginal capacity exiting the industry -- and that marginal capacity is understandably the hundreds of one or two truck operators that have less sophisticated marketing, less operational efficiency, and less scale.

Valuation

I have valued the company by taking the TTM results, and adjusting them for current exchange rates, normalized paper prices, acquisitions made in the last year, one-time acquisition-related charges, and a very small impact from COVID-19 in Q1.  As I am using TTM results, I am implicitly assuming that the company will generate modest organic growth offset by a modest permanent loss of business as a result of the pandemic.  I think you can model out other scenarios where the business permanently loses more EBITDA and still have a very large margin of safety at current prices, but I’ve modelled the above because it’s what I believe is most likely to happen.

As of Q1, TTM EBITDA is $4.8 million.  Assuming $135 per ton in average paper price (the 10-year average, and below the current price of ~$150), gets you to $6.2 M in TTM EBITDA.  Then I add: $200k for EBITDA at current exchange rates, $1.1 M for the full year impact of the Chicago acquisition, $1.0 M for the full year impact of the Connecticut acquisition, $300k for “vendor related consulting fees” (temporary expenses from recent acquisitions that will be rolling off), $300k for acquisition costs, and $200k for the estimated COVID-19 impact in Q1.  That gets you to $9.3 million in EBITDA in CAD.

At $0.39 the EV is $45 M, and so the EV/EBITDA is 4.9x.

As for a bridge to FCF.  From EBITDA I subtract: around $1.0 M in lease payments (largely leased offices/warehouses), $800k in interest, $2.2 M in capex (~7.0% of revenues), and $400k in taxes.  That gets you to $4.9 M in FCF in CAD.

At $0.39 the market cap is $30-31 M, and so the P/FCF is 6.2x.

I think it’s also important to note that the operational results were actually accelerating pre-pandemic and this fact definitely seems to have been ignored by the market.  Organic shredding comps in Q1 were +4% including the impact of COVID-19.  If you exclude the estimated pandemic impact, comps would have been closer to +10% based on my math -- the highest level in almost two years.  The company had also been in the process of replanning routes to optimize profitability and the positive impact from those efforts was just beginning to be realized.  Adjusting for paper prices, EBITDA margins from corporate operations increased over 400 bps year over year.  The bottom line is that I think by using TTM results, and considering the recency of some of these operational improvements, there is additional near-term upside that I haven’t really given them credit for that they should realize in future.

In terms of value -- I believe that the business is worth around $1.15 per share, roughly 3x the current share price.  That works out to a valuation of around 3.3x revenues, 11x EBITDA, and 18x FCF.  I believe this valuation is justified by the significant organic growth, high quality characteristics of the business, and industry transaction multiples.  I have not given them any credit for the significant potential acquisition growth; that said, when Mr. Market comes to his senses again, I think he is going to place a significant value on this future growth from acquisitions considering their strong historical track record for it, and the built-in pipeline that the franchisee network provides them with.

As explained previously, the company’s closest comp is Shred-It, and they were acquired by Stericycle for 13x EBITDA.  Recall Holdings is not quite as good of a comp but they were another large transaction, and they were acquired by Iron Mountain for 14.5x EBITDA.  I have heard that in recent years Stericycle has even been paying as much as 9-11x EBITDA and 3x revenues for tiny businesses that operate in a single market and would be a fraction the size of PROSHRED.

Management / Ownership

I’ve followed this company for roughly the last eight years and have been extremely impressed by the CEO, Jeffrey Hasham.  I think if you study the historical results you will see that he has excelled at both running the existing operations (consistently strong organic growth, improving profitability, etc) and making acquisitions at low valuations that create value for the company.

Insider ownership is around 34%, and the largest shareholder is billionaire Moray Tawse at 15%, a co-founder of First National, although he is probably better known by the public for his wineries.  The remaining ~20% is owned by the CEO and other directors.

There has also been recent insider buying at much higher prices.  Robert Crozier bought around $80k worth at $0.77 in December 2019, and then another $70k at current prices in April 2020.  I thought it was particularly interesting that the founder of PROSHRED -- who was ostensibly completely out of the business but probably knows it better than almost anyone -- called into the Q1 conference call to ask a question and disclosed that he too was buying at current prices.

Risks

• Offices that are currently closed could remain closed for longer than expected.

• There could be a return of the pandemic that causes offices that are presently open to close in the future.

• More employees could transition to working from home and have their employer not expect them to securely destroy documents than expected.

• The company could make a bad acquisition.

Catalyst

As more offices open up over time and revenues continue to rebound, I expect investors will feel that they have “better visibility” and become interested in the company again.

The company announces another value accretive acquisition.  They currently have the capacity to make both franchisee acquisitions or smaller tuck-ins.

The company is acquired.  This is a consolidating industry and the company is trading for an extremely low valuation, it would not surprise me to see either Stericycle or Iron Mountain try to buy them.