Description

Sharps Compliance (SMED) is a broken growth story after missing topline consensus for three straight quarters.  Expectations for continuing growth in the high-teens took the stock from $3 to $10 in three years.  Two consecutive quarterly topline misses (15%, 8% growth) brought the stock back below $4.50, which I see as a good entry point to hold for a few years.

Note: this is a microcap company ($75M) trading 50K shares per day.  June fiscal year.

Long thesis: This is a pretty good business with a long runway to grow profitably as they pick off business from the dominant and overpriced competitor.  There is good line of sight into their operating leverage, cost controls are solid and capital allocation is reasonable.  This means that figuring out the top line is the variable that matters.  Temporary disruptions to their retail and government markets have masked solid underlying revenue growth in line with previous expectations.  As growth gets back on track, stock can recover or surpass previous highs.

Sharps was previously written up on VIC in 2009 with the stock price 100% higher at $9.  At that time, the bull thesis was that this was an excellent company with a real barrier to entry--at current prices no longer necessary to the thesis.  Also, then the business was dominated by a government contract which doubled revenue in F10 and brought a major spike in operating earnings.  When that revenue proved to be one time in nature (Veterans Affairs cut spending after a year and canceled contract in 2012), the stock collapsed to <$3.

Since that time, the company has developed significant new sales channels with double digit revenue growth.  CEO David Tusa took the helm in F12 and has built out a solid sales operation, while customer retention is in the 98% range.  Their cost structure is highly fixed with a breakeven level at ~$25M in annual revenues.  They reached that revenue level by the Sept '13 quarter, and while there is some quarterly revenue lumpiness they are now in the black.  Going forward I expect them to reap the benefits of strong growth combined with high fixed costs.

The company has grown overall revenue at a 12% CAGR since F06, and 16% CAGR since CEO David Tusa took over and built up a real sales force.  If they continue in the low teens, the stock should at least double sometime by end of decade.  There is upside optionality if organic growth pushes into the mid/high teens, and from acquisitions.

The business

Sharps provides regulatory compliant disposal solutions for needles and medications to small/low volume customers.  They offer a US Mail based solution, which can be more cost effective than truck route based pickup.  

Disposal of medical sharps is understandably highly regulated, ever since miles of hypodermic needles washed up on New Jersey beaches in the late 1980s.  The EPA passed an act and businesses sprang up to provide and collect the now familiar red boxes for sharps and other medical waste.  Trucks pickup along a route and bring to a central processing facility for treatment in an autoclave (steam, pressure, time), and then the sharps can be dumped into designated landfill or shredded.  The local providers naturally got rolled up, with Stericycle (SRCL) as the final consolidator (they bought Waste Management's sharps business in the late 90s.)

SRCL has pushed their pricing power very heavily, particularly for smaller quantity customers.  For a small doctor/dentist office the sharps pickup is maybe $100 per month, so not a large cost for an essential service particularly if you're not sure about legitimacy of competitors.  Customer checks show that SRCL is quite aggressive, with examples of double digit price increases  and they have also communicated their pricing power on small businesses as an investment thesis to their investors.  See Feb 2012 investor call:

So why do we talk about so much around small customer focus? Quite simply, small accounts generate more gross margin than our higher LQ customers. Our SQ customer gross margins are in the range of 55% to 60%, and if you compare that to our LQ customers, which are in the high teens to mid 20%'s. So, obviously, we want to focus our growth in that higher margin business. And small accounts are more likely to outsource, not only medical waste, but also compliance services. So it's an easier upsell for our sales team, compared to the large quantity marketplace.

If you look back at Stericycle in Q4 of 1996, our gross margins, corporate gross margins were 21% but if you look at the mix of our customer revenue, 67% of our customer revenue, during that time, came from the large quantity or hospital market, the remainder from the small quantity customer. If you fast-forward to our latest quarter, our corporate margins are 45.1%; so we've more than doubled our gross margins. And if you look at the mix of our customers, 63% of our customer base now, our revenues come from small quantity customers and the remainder from large quantity customers.

Thus, we now have a price umbrella for a business critical service, and that's fertile ground for growth.  SMED estimates the TAM for this  market in the US to be ~$650M+ (800k offices @ $800 each.)  F16 revenue in this "Professional" segment will be about $7.6M, and has grown at a 30%+ CAGR for five years.  While this segment is now just over 20% of revenue, it's their most attractive market and in my view the driver of value going forward.

The remaining parts of the business are described below:

The retail business disposes of flu shot needles used in chain retail settings (CVS, etc.)  Sharps has dominant market share, seems to deliver at a reasonable price point, and I view this as pretty sticky business.  The growth driver is flu shots in the retail channel, which have been growing at mid-teens rate--consumers have shifted preference due to convenience/price, and now something like 20% of total US administered flu shots are through this channel.

Home health care used to be a bigger part of the business, but it's been difficult to grow.  Large fragmented market, accessed via distributors who are delivering a bunch of supplies including needle mail-back envelopes.  Revenue has basically been flat, it hasn't been an area of focus, and I don't expect them to get a lot of upside here.

Pharmaceutical may be their most interesting opportunity outside of professional.  They partner with manufacturers of specialty drugs (injectables), providing the disposal solution with a modest additional advantage of data tracking (drug companies get a view into regimen compliance.)  Growth for the past five years has been well above the company's long term goal of 20% for this segment, but is subject to the timing of contract signings when they generally get a bump from an inventory build.

Government is small now, though they signed a purchase agreement last fall with the Department of Veterans Affairs

for "up to $7 million per year."  When SMED was last written up on VIC back in 2009, the debate rightly centered on government.  In that case it was a large contract with the CDC, which resulted in a one-time revenue bump that they ran through the income statement.  This time around, new management, the contract is much less significant even if it comes through at a full $7M, and the potential for an earnings distortion is not really an issue.  Part of the recent weakness in the stock relates to the delays in government revenue, which investors expected to begin ramping up last quarter.  Government delays due to communication and systems are not uncommon; however I think prudent to view this segment with some conservativism.

Trend Growth

Quantifying various scenarios by segment gives a rough idea of the overall growth potential, with management's case somewhere between bull and base.  The bear scenario implies pretty much everything they try doesn't work.

Earnings Algorithm

Relatively fixed cost structure (autoclave operations with plenty of utilization room), with observable leverage on COGS line as well as SG&A.  Incremental gross margins are 50%, and incremental SG&A is 5-7%.

$1M in EBIT this year grows to $5.5/10.5/16.5 by F19 in above bear/base/bull scenarios.   Fully taxed that translates to $.21/.41/.65 in EPS.

Management

Tusa has a focus on execution and has shown he  knows how to get results out of a sales force.  He also seems pretty heavy handed, and this is quite clearly his company.  For what they're worth, online company reviews are terrible--Tusa is arrogant and a control freak.  From conversations, I could see how he might be difficult to work for.  Also, I've found him to instinctively be dismissive of risks--an immediate answer of "no, not a concern" though he'll be a little more circumspect when he's had a couple minutes to think about it.  While I don't see this as a positive, and it could create issues down the road, I see as largely not relevant for a $35M revenue company which is delivering results.  To the contrary, sometimes a company like this can grow a lot bigger than it is just by brute force from a commercial executor type CEO.

The sales force is key to this business.  Tusa has built what looks to be a very competent/efficient inside sales team, combined with some strategic hires to go out and get somewhat larger doctor's groups and pharma companies.  Results are there, strong topline growth with very minimal additions to selling expenses.

Capital Allocation

The one change here is their attempts to build out a route based pickup system for the professional market.  They made their first acquisition, for $1.5M in late 2015, of a route-based pickup service in Pennsylvania.  They're looking for more, dependent on finding motivated sellers.  They're willing to pay 1.2-2.5x revenue on businesses with 10-15% operating margins.  Post integration, they can strip out costs and achieve something near their incremental company margins.  So buying businesses at say 13-14x EBIT and <6.5x post synergies.  

Valuation

Stock trades ~14x consensus F17 earnings (June FY) ex-cash.

Downside if they miss I believe is captured in above case, $.21 in F19 earnings.  At that point professional market would be over a third of revenue and a bigger contributor to total growth.  Think it isn't unreasonable to put 14x on a company that would be growing 10%+, with a little cash generated in the meantime, so a downside around $3

Base and bull scenarios deserve higher multiples.  In a base case, profitable mid teens growth on $.41 EPS should give an IRR over 20% for three years.  There is clear upside beyond that.

Key Risks

• Slow growth in Pharmaceutical/Retail/Government:  Pharm contracts may not come through, and it's tough to get visibility into an unpredictable order flow.  Retail could see slow flu seasons or a reversal of share gains (chain drugstores/clinics lose share to hospitals?  Or major inflection in the growth of nasal flu spray vs needles?  Don't see either as likely.)  Government contracts are unpredictable, and this one could disappoint.  Mitigant: I think reasonable worst case scenarios are captured in the bear case, and these are in fact somewhat uncorrelated.

• Management: I could be wrong on my take as CEO personality being a net positive on this company.  Not sure how to precisely quantify this risk, doesn't seem like even major personnel turnover moves a lot of this sticky revenue.

• Overpaying for acquisitions, or stupid pushing of price putting customer relationships at risk.  These would be quite bad, but in my view management understands these and isn't going to head down either road.

• Competition: a major competitor with deep pockets could impact growth rates.  I don't see as very likely, as the waste management companies have gotten out of this, and distributors like Henry Schein/Cintas began using Sharps for this service in the past few years.  I don't view the barriers to entry as huge, but it does take salespeople and time.  Stericycle could theoretically walk back their prices, but the price umbrella is significant enough it would be hard for them to undo it even if they wanted to.  There's a long runway to grow, so enough room for more than SMED.  

Catalyst

• Government contract revenue could start flowing through in next couple quarters
• Anything that brings revenue growth back to more normal levels
• Continued execution and demonstration of their operating leverage