HCCI - Heritage Crystal Clean

[jawn619]

Heritage Crystal Clean is a combination of a premium business with a durable competitive advantage and considerable growth prospects and a business in an industry consolidation. The Business is run by experienced and financially incentivized owners. We believe the negative commodity environment and sustained low oil prices gives opportunistic buyers a chance to own two businesses with bright prospects at a cheap price that have little exposure to the price of oil.

 

Read the full writeup here.

 

http://raritancapital.com/currentideas/hcci/

[kirkomi]

I fail to see the durability and competitive advantage of the premium business.

 

They jump from sustained profitability to durable competitive advantage. I am quite certain that this logical jump is a fallacy unless they can actually point to a better reason.

[jawn619]

Summary

Heritage Crystal Clean is a combination of a premium Environmental Services  business with considerable growth prospects and an Oil collection and Re-refining business in an industry consolidation. The company is run by experienced and financially aligned owners. Opportunistic buyers have a chance to own two businesses with bright prospects that have low exposure to oil prices.

 

Business Description

The oil re-refining and recycling segment consists of used oil collection activities, re-refining and sale of recycled fuel oil. The company operates a used oil re-refinery with an annual capacity of 75M gallons/year. It makes sense to think of this business in two parts

Collecting Oil: Historically, Heritage Crystal Clean and its competitors have been able to earn reasonable returns by charging fees to collect oil from customers. Currently, Heritage and its competitors are paying their customers to collect oil to avoid losing market share. We have reason to believe that this industry is in consolidation and that this irrational pricing will not continue for long. Industry leader Clean Harbors acquired Safety-Kleen and Heritage Crystal Clean, the 2nd largest largest player, recently acquired FCC environmental. In 2014, HCCI lowered its weighted average cost paid to generators by .09/gallon.

Refining and Selling oil: The Company re-refines the oil it collects and sells it at a markup. The company decided to take an impairment loss when oil prices plummeted. This is a spread business and unlikely to lose money for a sustained amount of time.

Let’s Look at competitor Clean Harbors’s oil re-refining business. It is able to earn around $60M of EBITDA per year before corporate G&A off $400M in sales. Going forward we believe Heritage Crystal Clean can obtain similar EBITDA margins off its $120M in revenues. This equates to about $15M in EBITDA before corporate SG&A.

 

FCCE Acquisition

In Q3 of 2014 HCCI acquired FCCE for $90M. The business is EBITDA breakeven, but historically has seen EBITDA as high as $19M/yr. Because of the consolidation mentioned above, we believe EBITDA will normalize to around $10M/yr. Management has also guided $20M/yr of cost synergies but has already realized synergies at a run rate of $22M/yr.

 

The Environmental Services segment consists of cleaning parts, containerized waste management, vacuum truck services, and antifreeze recycling activities. Many of these substances are subject to extensive and complex regulations, and mismanagement can result in citations, penalties, and substantial direct costs to the generator. This business is a gem. Revenue growth has been fantastic for as long as data is available, driven by both branch/customer growth and price increases. At the end of 2014, the company opened 10 more branches. Much of the growth is organic, and comes from integrating the routes already traveled from its used oil business. Below are summary statistics for the past 5 years.

 

Revenue/Profit before corporate G&A (in millions)

2010:104/21.2

2011:119.5/26.2

2012: 139/29.5

2013: 157/41.9

2014: 189/47.6

2015(1H) : 105.8/ 28.2

 

Valuation

OIL Services Business EBITDA(normalized) $15M

FCC Oil Services Business EBITDA(normalized) $10M

Environmental Services Business EBITDA $60M(growing at 15% a year)

Corporate SG&A $45M/yr - $22M/yr synergies =23M/yr

4.5X EV/EBITDA assuming oil businesses normalize

8X EV/EBITDA assuming oil businesses don’t normalize

 

 

 

[KJP]

I fail to see the durability and competitive advantage of the premium business.

 

They jump from sustained profitability to durable competitive advantage. I am quite certain that this logical jump is a fallacy unless they can actually point to a better reason.

 

Although has the company has some proprietary technology and some customer captivity (e.g., automatically renewing contracts), isn't the main competitive advantage here scale, and particularly local economies of scale?  The more customers a company like this has in a particular geographic area, the more efficiently it can use its assets.  Management appears to understand this, because their presentations repeatedly refer to "route density" as the key to profitability. 

 

The thoughts above apply only to the environmental services business.  Why is the company so focused on expanding the oil business?  I understand the large addressable market, but what is their competitive advantage in that business?  Or is taking used oil a service they need to provide to customers in order to get them to use the company's environmental services?

[mcliu]

Where do you get the $23 million in corporate SG&A? Q2 corporate SG&A was at $10.5 million, so $43 million annualized.

 

If the $22 million in synergies was realized, shouldn't the Q2 corporate SG&A run rate be something around $5.5 million?

[jawn619]

Where do you get the $23 million in corporate SG&A? Q2 corporate SG&A was at $10.5 million, so $43 million annualized.

 

If the $22 million in synergies was realized, shouldn't the Q2 corporate SG&A run rate be something around $5.5 million?

 

My apologies,

 

You're right. The synergies show up in the decreased operating costs in the oil business, not corporate SG&A

[KJP]

Jawn:  Does Heritage having any competitive advantage in the re-refining business?  I'm concerned that it doesn't have any, and the business is a money pit that helps management tout revenue growth but doesn't actually generate returns for shareholders.  See, e.g., the statements in the 2014 10-K about competitors expanding their re-refining capacity and virgin lubricating base oil producers also expanding capacity.

 

Also, is the oil collection business necessary to get customers for environmental services?  See 2014 10-K at 10 (competitors "generally offer parts cleaning services ancillary to a primary line of business, such as used oil collection, in order to present a more complete menu to customers").

[jawn619]

Jawn:  Does Heritage having any competitive advantage in the re-refining business?  I'm concerned that it doesn't have any, and the business is a money pit that helps management tout revenue growth but doesn't actually generate returns for shareholders.  See, e.g., the statements in the 2014 10-K about competitors expanding their re-refining capacity and virgin lubricating base oil producers also expanding capacity.

 

Also, is the oil collection business necessary to get customers for environmental services?  See 2014 10-K at 10 (competitors "generally offer parts cleaning services ancillary to a primary line of business, such as used oil collection, in order to present a more complete menu to customers").

 

The oil services business doesn't have any particular competitive advantage that I can see. It is the second largest player in the market so scale maybe...but the lack of pricing power is disheartening. You made a good point on geographic density as way of keeping customers captive.

 

Believe it or not, the oil service businesses were once profitable. It reminds me the story of Micron where for many years players competed for market share at the expense of profits. When oil prices were high and trending upwards, you saw oil collectors change from charging customers to collect to paying them to collect, basically speculating on higher oil prices with the inventory. Now that oil prices are falling, it makes sense again for collectors to start charging. Once competitors leave or get bought after losing too much money, the remaining players can return to profitability.

 

I don't think management is bad at capital allocation, but their timing is unlucky.  They finished their re-refinery right before oil prices collapsed.

 

There is “synergy” from the environmental services business being incorporated to the routes traveled by oil collection business. You see this in a lot of industries where “ancillary services” actually have higher margins than the main business.

 

[KJP]

Jawn,

 

I've looked into the company further and have a few thoughts and questions.

 

Environmental Services

1) The model on your website appears to assume around 28% EBIT margins before Corporate SG&A going forward.  But management has historically targeted 25% margins in this segment.  When margins rise about that, they take on additional expenses to fuel growth.  So, it seems unrealistic to assume both growth and margins above 25%.  (Recent margins have been around 27% due to the falling cost of oil driving down the cost of solvent.)

 

2) Have you been able to estimate the actual returns on invested capital in this business?  Environmental Services is capital intensive, because it needs parts cleaning machines and trucks.  The company appears to fund most of those capital needs through operating leases, but the current disclosures make it very difficult to tell exactly how much capital is being used in this business.  I'm wondering how much of the returns generated by this business are attributable to the leverage implicit in the operating leases.  Put another way, how much of the return on equity is generated by leverage, rather than return on assets? 

 

Oil Collection and Re-refining

 

Re-refined oil is a commodity product, so I think the only possible competitive advantage is cost to produce re-refined oil.  Cost to produce, in turn, is determined by (i) the cost to acquire used oil (potentially negative if you're paid to collect); (ii) the cost to collect and transport used oil to the re-refinery; and (iii) the cost to run the re-refinery. 

 

Cost to obtain oil:  It doesn't appear that sellers care much who buys their used oil, they just want the best price (or to pay the least).  So, it's hard to obtain or maintain any advantage in the cost to acquire oil. 

 

Refining costs: The cost to run the re-refinery is all about scale and making sure that the refinery runs at maximum output, because it has very high fixed costs.  Moreover, anyone with capital can construct a refinery, so it's hard to see how the refinery is going to create any real competitive advantage.  But is it reasonable to assume that Heritage will obtain the same margins as Clean Harbors if it has less refining capacity? 

 

Cost to collect and transport:  This is determined almost entirely by route density.  The company needs to maximize the amount of oil collected by each truck.  But the amount you're willing to pay for used oil influences the amount of oil you're going to collect -- if you pay systematically less than competitors, you'll lose volume, as Heritage has this year.  In the past, collection and transport has been the weakest link in Heritage's business.  Indeed, in 2014, management acknowledged that, because of the company's lack of route density in oil collection, the used oil it collected was actually more expensive than the used oil it could buy from third-party oil collectors.  That's why the company essentially had to do the FCC Environmental transaction -- it needed the density of FCC's oil routes.  But it remains to be seen whether the company has maximized its efficiency in this area. 

 

Even assuming Heritage is as efficient as it can be, there's no guarantee that it can make any money in this business.  The company's re-refined lube oil competes with lube oil produced by virgin oil refiners.  Those refineries have an entirely different cost structure than re-refiners, because they rely on the price of obtaining and transporting virgin crude.  If crude prices remain low enough, it may be impossible to match the cost structure of virgin oil refiners.  The answer, I suppose, is that Heritage and the other oil collectors can keep raising the price they demand to collect used oil until they can compete effectively with virgin oil refiners.  But the problem with this approach is that re-refining is not the only use for used oil, so it's not clear that the price of used oil will fall far enough (or go negative enough) to allow Heritage to compete with virgin refiners. 

 

Long story short, this business appears much more complicated than a simple spread business.  It's also very capital intensive because of the refinery and the trucks needed to collect used oil.  Also, as far as I can tell, Heritage has always lost money on this business, once you attribute some corporate SG&A to it.  So, at the end of the day, what value does this business really have, particularly if the company continues to pour capital into it and continues to get returns that are lower than its cost of capital?

 

 

[jawn619]

KJP, thank you for your questions. Really appreciate how you did a fair amount of work on the name too. Always enjoy discussions with an informed investor! I’ll start with a response to your thoughts on the oil services business.

 

Oil Services Business

 

Re-refined oil is a commodity product, so I think the only possible competitive advantage is cost to produce re-refined oil. Cost to produce, in turn, is determined by (i) the cost to acquire used oil (potentially negative if you're paid to collect); (ii) the cost to collect and transport used oil to the re-refinery; and (iii) the cost to run the re-refinery.

 

I agree 100%. This is a commodity business. Worse yet, their refinery historically runs at 60% capacity, which I assume is the case going forward. There is little pricing power but seeing HCCI raise prices for collection of oil in the last year and a half is a positive sign. I also agree when you say that it is a capital intensive business so it will not have high returns on invested capital. But in the long term, I don’t think it will lose money, and I don’t think the businesses is worth nothing. In my assumptions, I assume the business normalizes to $10M/yr in EBITDA, which at best will be worth a 6-10x multiple. So that’s only $60-100M for a business that currently has an enterprise value of $320M.

 

The key is the environmental services business, which is where most of the growth, profit before corporate G&A, and competitive advantage is. That is where the value lies and where I’ll spend most of my time.

 

Environmental Services

1) The model on your website appears to assume around 28% EBIT margins before Corporate SG&A going forward. But management has historically targeted 25% margins in this segment. When margins rise about that, they take on additional expenses to fuel growth. So, it seems unrealistic to assume both growth and margins above 25%. (Recent margins have been around 27% due to the falling cost of oil driving down the cost of solvent.)

 

I think i was reasonable with my assumptions because I assume slowing growth in both product and services. Historically HCCI has grown product revenue at 29% and services at 19%, at the end of my model I assume 17% for products and 14% for services. Management had stated the benefit from lower cost of solvent is around 2%. I assume a 1% decrease in opex per year in operating expenses as they grow and scale which I don’t think is too wild.

 

2) Have you been able to estimate the actual returns on invested capital in this business? Environmental Services is capital intensive, because it needs parts cleaning machines and trucks. The company appears to fund most of those capital needs through operating leases, but the current disclosures make it very difficult to tell exactly how much capital is being used in this business. I'm wondering how much of the returns generated by this business are attributable to the leverage implicit in the operating leases. Put another way, how much of the return on equity is generated by leverage, rather than return on assets?

 

It’s tough to estimate the actual returns on invested capital in this business because of how intertwined the two businesses are. The routes traveled by the environmental services are the same ones traveled by the oil services business.

 

Also, regarding operating leases...if the company had capital leases instead on the PPE it uses, it would be a lot easier to discern how much capital is being used and then you can more easily find what ROIC would be. But you would also have to take into account that the numerator part of ROIC would be a higher because it no longer has to pay the rent expense. Again, hard to get a clear answer but I think the way the company uses operating leases is just fine.

 

Just some closing thoughts. The environmental services business is a bomb ass business. It’s customers are aftermarket services in a fragmented regional market (quick lubes, car repair shops, other smaller industrial services) who need HCCI’s services and don’t want to deal with the regulatory hassle of disposing of hazardous waste. No customer concentration. A history of growth and pricing increases and a bright prospects for the future. Barriers to entry because of how long it takes to build routes. HCCI is the second largest player in the environmental services market, with opportunities to increase scale.

 

P.S. thanks again for putting in a lot of due diligence and sparking some great conversation!

[KJP]

Jawn:

 

Thanks for the response.  I agree that Environmental Services looks like it could be a great business.  A few additional thoughts:   

 

1) I get a CAGR for sales of 15.5% if you look from 2003 through 2014 (from $38.7 million to $189 million over 11 years) or 12.5% if you look from 2006 to 2014 (from $73 million to $189 million over 8 years).  I believe 12.5% is pretty close to what management reports in its annual reports.  I'm not sure how you get historical CAGR of over 20%.

 

2) If you go back to 2008 -- the last pre-recession year that didn't include significant used oil business -- corporate SG&A was 15.74% of revenue ($17 million versus $108 million in revenue).  As you would expect, SG&A as a percentage of revenue had trended downward from 23% of revenue back in 2003.  It is reasonable to expect the corporate SG&A attributable to the Environmental business to have continued to fall as a percentage of Environmental revenue as the business grew.  It's hard to say where the margin expansion would end, but let's assume that the doubling of the Environmental business from 2008 to the present would have driven down Environmental SG&A to around 13% of revenue.  In that case, it's reasonable to assume that a standalone Environmental Services business would have EBIT margins of 12-14% (this assumes a sustainable margin before SG&A of 25-27%).  On current run-rate Environmental revenue of about $225 million, that's $27 - $31 million of EBIT.  And that EBIT is growing slightly faster than revenue because of the operating leverage.  I think the right multiple to put on that EBIT number depends on the underlying ROIC. 

 

3) The above analysis would attribute about $30 million in corporate SG&A to Environmental Services ($225 million * .13).  The remaining $12 million or so a year would be attributable to the Oil Business.  With that level of attribution (which I think may understate the amount actually attributable to the Oil Business), will the Oil Business ever really be profitable?

 

4) Does the Oil Business actually enjoy significant cost synergies with the Environmental Services business?  Although the routes may be the same, the trucks are not.  Oil Collection uses it own specialized truck and its own holding tanks.  Different trucks are used for Vacuum Services and Containerized Waste. 

 

5) At the end of the day, you can see a path to profitability for the Oil Business if it can charge enough for collecting used oil.  But that seems like a crapshoot.  It's also plausible that the business continues to lose money after attributing Corporate SG&A.  And I don't see management selling the oil business.  They have a long history with it and appear to love it.  If anything, it seems more likely that they're going to dump more money into it.  So, on a ongoing basis, I see an argument that the Oil Business has zero or even negative value.  Of course, it would have value if sold, but that requires a management willing to sell.