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Stericycle's competitive advantages such as an unmatched network of processing, collection, and transfer sites worldwide, industry leading efficiency, and a value proposition centered around making customers more efficient all align well with broad industry and demographic trends. The trends that Stericycle should benefit from include heightened medical industry appetite for outsourcing due to rising health care costs and increasing regulatory burdens, and an aging U.S. population that is demanding more medical services. Also, the medical waste industry has proven very recession resistant.
Three primary competitors are Waste Management (WM), Republic Services Group (RSG), and Shanks Group PLC which are integrated solid waste service companies that have medical waste units among their other offerings. Shanks Group PLC is located in Scotland and its operations are exclusively in Europe. Its stock does not trade in the United States. At a recent share price of about $88, Stericycle's shares trade at a premium price to earnings ratio of about 24x versus its rivals. Waste Management was recently at about $35 per share and trades at a price to earnings ratio of about 15x while Republic Services trades at a price to earnings ratio of about 13x at a recent price of about $30 per share. The premium paid for Stericycle is due to its future growth rate which analysts estimate at about 14% while Waste Management is expected to grow earnings at about 8.5% and Republic Services at about 11%. Stericycle trades at a multiple that is comparable to Waste Management at about 1.8x price to earnings to growth while Republic Services has a price to earnings to growth ratio of about 1.2x. The earnings growth expectation for Stericycle is reasonable given the company's competitive advantages, industry and demographic trends, and long term growth rate of earnings per share of about 18% annually and long term revenue growth rate of about 16% annually. Also worth noting is that this earnings growth rate is expected even though revenue growth is expected to be only about 9% which is very achievable as it is actually reduced from the long term average.
Fair value for Stericycle is about $89 per share or roughly where the shares trade currently, based on discounted cash flows that are expected to grow at the same 15% clip that they have grown historically. The company has consistently grown its operating cash flow and free cash flow with only two periods when year over year comparisons were negative. 2011 was one of those periods and was the result of working capital changes that offset an increase in net income of about 13%, leading to a decline of about 6% in operating cash flow. Free cash flow declined by about 9% last year due to the decline in operating cash flow and an increase in capital spending of about 10%. I expect that over the long term, Stericycle will be able to maintain its competitive position as the leader of the medical waste management industry and as a result it will reap outsized benefits of significant changes in the health care industry which will support continued high growth in cash flow. Specifically, increased complexity and stringency of medical waste regulation will boost demand for outsourced solutions, especially from large medical organizations that presently dispose of waste in-house. This dynamic should help Stericycle gain pricing power over its large customers which benefits cash flow. Another change in the health care industry that favors Stericycle is the aging of the population in the United States. Overall, this trend will boost demand for Stericycle's services and products and will boost cash flow because demand is expected to shift to higher margin, small quantity health care providers such as acute care clinics. This trend comes with a trade off as it will reduce demand from large hospital organizations. The company will need to replace revenue lost from its large customers as this trend develops.
Stericycle is a fantastic company with a history of outstanding operational execution and a future that promises more of the same. I anticipate a smooth transition to the new CEO in 2013 and the industry faces some difficult but potentially favorable changes that should allow Stericycle to exploit its competitive advantages for disproportionate value creation. However, shares are currently fully valued at only about 8% below the all time high achieved in April of 2011 and I want to see a pullback from this level before pulling the trigger on a buy. At a margin of safety of 20%, shares should be bought at around $71 per share.
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