About Me

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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Wednesday, May 15, 2013

From Omaha, With Love

Arrived in Omaha on a cold and rainy Friday evening overdressed and not knowing what to expect (you can get by in jeans, a flannel and workboots). I shared a room downtown with a value fund friend and agreed to go to the arena early to help him save seats. So at 5:45AM went to the Hilton to the skybridge entrance and at 6:30 did the high net worth wal*mart dash to get seats. The rest of the day was kind of surreal but here's a few things I saw and heard ...

Every meeting starts out with a few short movies and clips. This year's included a brilliant Breaking Bad spoof where Bryan Cranston and Aaron Paul (i.e Mr. White and Jesse Pinkman) cook-up out in the desert, but instead of making the blue meth, they make peanut brittle. ("Mr. White, I can't sling peanut brittle on the corner!"). But of course it's the best peanut brittle ever and WB shows up to buy them out. After some hard core negotiating they agree.

There was also a silly spoof where WB wanted to appear opposite Arnold Schwarzenegger in Terminator 5. Arnold chooses Charlie instead. Oh, and they premiered a GEICO ad ("as happy as a camel on hump day") and a version of YMCA that Buffett really grooved to: "We love the managers of BRKA". Silly.

I spent much of this time chatting with an analyst for a university endowment who shared with me his thoughts on starting a fund; "Whatever you start, you need to consider it as something to be built for decades." That's good advice about any career choice.

Charlie really had the most pithy and funniest quotes of the day so I'll start with him.

CM -
"my old age might come on at any time"
"game of life is a game of everlasting learning"
"it's important to know the edge of competency"
"i want to tell the Mungers in the audience don't be so stupid to sell the shares"
"it's true there's a history of big companies making bad acquisitions but we think we have a better system"
"you can't succeed at something you don't like doing. we were lucky to find things we liked doing early in life"
[on inflation] printing money has the potential to be inflationary - the professionals wish it were - but Japan has tried every trick in the economists book for the last 20 years and so far no inflation ... "this is a huge experiment"

[on making decisions] "shouldn't make decisions while tired. concurrently, making decisions is tiring. we have found that sugar and caffeine are great for making decisions."
[on newspapers, after WB gave a long explanation for why he invests in them] "it's an exception and you like doing it"
[on short selling] "we don't like trading agony for money"


WB -
"our competitive advantage is staying sane when other people are crazy"
"we treat subsidiaries the way we would want to be treated and be a good partner"
[on being thanked for letting investors in early] "if we'd owned a coat business we would have kept you outside"
"the distinction is a person who spends time learning new businesses vs. the person investing at the wrong time"
[on AIG poaching] "they reached out to us ... waited until AIG repaid the loans ... possibly more to follow"
[on question from doug kass about paying premia for acquisitions] "it's not bad to pay a premium for good management ... we paid up for GEICO ... we will pay up for extraordinary businesses"
[on HOG debt] "any company that gets its customers to tattoo ads on their chests must be a good company"
[asked if CM and WB should move closer to each other] "we know what each other thinks now. we used to talk a lot when it was expensive to call. now it's cheap and we don't have to talk."

mgr of BNSF -
[on the impact to rail assets if power plants convert from coal to natural gas] "oil by rail will remain important for a long time. one of the myths is that oil moves faster by pipeline but it actually moves faster by rail and it's more flexible. currently handling 650kbpd by rail and expect it to go to 1.2mbpd"


Thursday, May 2, 2013

A Short Call on CLH (written for hedge fund 3/22/13)

Price                                      $58 (at time this was written) 
Estimated fair value                $50
Shares Outstanding                60M
Market Cap                            $3.5B
Total debt                              $1.4B
Ent Value                               $4.9B

In our view, CLH is out over its skis, having made a (classic) mistake of acquiring (sexy) business at high multiples near the peak of the cycle, attracted most likely to its own success in its core business. I think the word is “hubris”, something the Greeks wrote about many many years ago. Recommendation: SHORT. 

Since its founding in 1980 by CEO Alan McKim, Clean Harbors (CLH) has been a major consolidator within hazardous waste industry. However, since 2009, it has "di-worse-ified" via acquisitions into non-core / non-waste / oil and gas field services that damage the attributes that had previously made it a great investment. These acquisitions face cyclical headwinds. 

The good news is that hazardous waste is a “moat” business (though still procyclical). The waste business is characterized by tight regulations, high fixed costs, substantial land / asset development costs, and significant investments in transportation and logistics that protects it from outside competitors, provides pricing power and reasonably strong free cash flow. However, it is not as defensive as one might think given its exposure to cyclical industrial businesses that generate waste, such as mining, chemicals and energy. 

Historically, the waste business – part of the "Technical Services" segment that includes landfill and incinerators – contributed around 45% of revenues and EBITDA. But with recent acquisitions, the contribution is likely to drop closer to 25% (and if it doesn't, it's b/c the acquisitions are not pulling their weight). 

In addition to its waste management business, CLH also has a Field Services business that helps institutions and companies manage the remediation and cleanup of their environmental waste, be they school labs, PCB’s, refineries, pipeline spills, etc. The Field Services business has a base business of stable recurring revenue and single digit / low double digit margin maintenance contracts and a higher margin / highly unpredictable disaster management piece. These services help the bottom line and feed capacity into the landfill and incinerators.

But recent acquisitions yield di-worse-ification. Not enough to leave the waste services business alone, CLH has still another business - in fact it has four other businesses - and these additional services are the catalysts to our negative call on the stock. 

These four business are Industrial Services (refinery turnaround, lodging and oil sands region maintenance), Oil/Gas Field Services (oil sands and Baaken shale exploration), and with the recent acquisition of Safety Kleen, the largest re-refining capacity in N. America and a national parts cleaning business. 

We outline in more detail our negative views on the oil/gas services business and the Safety Kleen acquisitions but on the latter issue simply note; 

the core CLH business is paid to take waste from customers in a market where it is a price maker while SK pays for waste to convert into a commodity product as a price taker and unfortunately in a market where supply capacity is expected to double. This is not an attractive model. 

Despite this diversification, the stock continues to trade as if it’s still a highly protected non-price sensitive business. But it is no longer that kind of business. Historically, the waste business – including the landfill, incinerators - and the field services pieces together contributed between 70% and 80% of revenues and EBITDA. However, with these additional business, contribution from the highly protected, high free cash flow generating business, now contributes by our estimate just 35% of revenues and 45% of segment EBITDA (before unallocated corporate). Investors have not digested these changes.

The capital structure furthermore puts the company at risk. The expansion since 2009 into non-core business was primarily debt enabled and has lead to a capital structure that is ~100% debt / equity, 50% debt / total cap and 3x debt to annualized EBITDA. On one hand, it is aligned with the median for the rest of the waste services industry. On the other hand, no one else in the waste services peer group has the same exposure to procyclical industrial services as CLH.

Slowing core growth. The company is not transparent enough to provide organic vs acquired growth and this lack of disclosure masks the precise decline in core revenues and earnings. But we have seen negative core growth since 2010 when EPS from continuous operations peaked at $2.44 before declining to $2.23 in 2011 and $1.87 in 2012 (after backing out a one-time tax benefit). Over that time EBITDA grew from $315 / $350 / $383M in 2010 / 2011 / 2012, with the bulk from 2010 to 2011 from the one-time benefit of the gulf coast clean-up in 2010 and in 2011 the acquisition of Peak Energy (~$25M in acquired EBITDA).

Volume concerns in the core landfill business. EPA data indicate a consistent decline in volume at CLH’s handling / incineration facilities during the recession. We expect a continued arrest in mine-related production concurrent with the easing of mineral prices (with these high fixed cost business, it’s either on or off). What’s strange about the data analysis – and something we need to better understand – is why revenues in the Technical Services segment has no apparent relationship with volume. (We have reached out to EPA and they indicated that the data should be accurate).

Waste Volumes Processed by CLH Facilities vs Technical Services revenues

Source: EPA & Company Reports

Value destructive acquisitions that increases risk in the business model and cash flows. The company has historically grown via acquisitions in its core waste markets. However, beginning in 2009 and more substantially in 2011 and 2012, acquisitions moved outside of “bolt on” acquisitions in core cash flow generating waste markets into non-related, cyclical and highly competitive oil/gas services markets via Peak (energy and gas drilling) and lower margin re-refining markets via Safety Kleen.



Headwinds – and there are several - in the oil/gas services business. These include rig count reduction from low natural gas prices in the Baaken shale regions, current and expected future production declines in the Canadian oil sands due to the combination of demand reductions from the US (higher CAFÉ standards, as we’ve seen in past cycles), more domestic production in the US, and the eventual resumption of lower priced imports from Venezuela (heavy oil similar to what we import from Canada). The derivative impact of lower production in Canadian oil sands adds a negative impact on the Industrial services / lodging business in that region.

Overall string of low quality earnings. Adjusted net EBITDA over the last three years was $1B while FCF over the same time frame was $268M. We view the delta as a symptom of low quality earnings and in fact DSO’s expanded from 74 days in 2010 to 95 days in 2012 (28%, roughly in line with the 26% growth in revenues over the same time frame). Another area of concern on earnings quality is the roughly $170M (pre Safety Kleen acquisition) accrued closure and environmental remediation liabilities. This represents roughly 12% of total liabilities. The company is required to account for future expenses of closing and remediating landfills based on expected costs from a third party provider. Since CLH performs the closure costs on its own, this account is persistently overstated.

CLH multiples and leverage ratios remain in line with its environmental services peer group. However, the due to acquisitions the dynamics of the business have changed. The core “Technical Services” segment (i.e. landfill and incinerators) represented just 25% of revenues in 2012 on a pro-forma basis (assuming SK acquisition occurred in beginning of 2012). The company shares a valuation and debt/equity ratio with its landfill / incinerator peers but has cash flow dynamics that have strayed from its peers concurrent with increased risk in its business model.


Source: Factset

Operationally, the company’s margins have lagged peers on a trailing 12-mos basis. This situation is likely to persist given the acquisition of the lower margin SK business.


Source: Factset

And finally, we see little opportunities for organic revenue growth. The company is not particularly well positioned in the wet gas regions to benefit from the “shale gas” explosion, positioned around and to dry gas clients. It’s industrial and oil/gas services business are clustered around the oil sands regions where price declines have already halted certain construction projects and will likely lead to decreased production growth. We fear further compression of organic volumes driven by lower commodity prices negatively impacting the metals mining industry, which is the largest producer of hazardous waste processed by third party facilities in the country.



Given my forecast, I estimate a fair value using peer group comps against my forecasts of ~$50 



BUSINESS DESCRIPTION

Based in Norwell, MA and incorporated 1980, the company reports four organic segments with two additional segments that result from the Safety Kleen acquisition:

·        Technical services. hazardous materials mgmt. includes incinerators, landfills and wastewater and other treatment facilities
·        Field services. scheduled or (mostly) emergency field and offsite cleanup services, includes tanks, decontamination, remediation and spills
·        Industrial services. Scheduled asset maintenance services at refineries, chemical plants, oil sands facilities and other industrial facilities cleaning as well as catalyst handling and decoking + lodging / drill camp accommodations in the oil sands
·        Oil & Gas field services. fluid handling, equipment rentals, exploration, mapping, directional boring to oil/gas and power … entered business through acquisitions of Eveready and Peak Energy
·        Re-refining. (SK) owns and operates two oil re-refineries in East Chicago, IN (largest in N. America) and Breslau, ONT (largest in Canada). These two facilities represent approximately 60% of the total oil re-refining capacity in North America. Total US capacity is expected to double in next five years
·        Environmental services. (SK) Parts cleaning, containerized waste, oil collection and RFO.

Broadly speaking, Technical + Field are part of “CLH Environmental Services” and Industrial + Oil/Gas are part of CLH “Energy and Industrial Services” I anticipate SK enviro svcs will be folded into the industrial services segment and re-refining will remain on its own and perhaps be sold eventually. [NOTE, I WAS WRONG! IN 1Q13 THE COMPANY FOLDED THE REPORTING STRUCCTURE OF INDUSTRIAL AND FIELD SERVICES INTO ONE UNIT “INDUSTRIAL AND FIELD SERVICES” AND REPORTED SK REFINING AND SK ENVIRONMENTAL AS STANDALONE SEGMENTS].

Stock valuation is driven by performance in two segments: The core / cash cow landfill and incineration business with additional upside from the higher beta oil/gas field services segment. Market seems to discount one-off Field Service work and overall Industrial Services business.

Historical (Pre-Safety Kleen) Segment EBITDA Mix vs EV / Annualized EBITDA 2010-2012.


KEY CONSIDERATIONS: TECHNICAL SERVICES (LANDFILLS / INCINERATORS)
·        Landfill / incineration is a volume business. It is cyclical, particularly on the hazardous waste side which is driven by industrial activity
·        It is not very price sensitive. I saw evidence of recent 8% price increases to a large public client in 2012
·        It is difficult to permit and expand a landfill / incinerator, this protects competitive behavior
·        In general, this is a great business with low growth and stable margins
·        However, in the famous words of Peter Lynch, I think the company risks “diworsification” given recent acquisitions to non-core businesses

Top-10 industries (2011) transferring hazardous waste to offsite RCRA C and other landfills

Largest disposers are metals / mining +1B lbs but potential  to decline on lower resource prices, electrical utilities ~600M lbs (but declining on conversion to NG and reduction and coal and still prob not a driver of CLH revenues, and chemicals ~450M lbs and very strong potential growth area on NG expansion / availability

Total Transfers of Hazardous Waste to Offsite Facilities (1991-2011 All US / All Industries) - note cyclical decline.
Offsite disposal is small but growing percentage of total released environmental waste.

Hazardous Waste / Solvent Recovery Industry trends –diversion from waste stream to recycling a likely driver of SK acquisition
Shift towards more recycling is a benefit – and perhaps a justification – for the environmental services portion of the SK acquisition. It draws to my mind the possibility that CLH sells off the re-refining assets to HCCI or another pure player.


KEY CONSIDERATIONS: FIELD SERVICES
Excluding emergency response work, this is a $200M -$240M annual revenue business with a core high S/D or low teen EBITDA margin. The benefit from ER work is twofold; first, it has high incremental margins in the 20% - 30% range. Second, it scales the fixed costs of the business, improving margins on the base business as well.

However, for obvious reasons (weather and unexpected disasters), the segment is impossible to model. Regardless, the market seems to look completely past the impact of the ER business anyway. It is not a material reason to own the stock.

This segment compares to Pike Electric Corp (PIKE), which does post-hurricane / post-storm related electrical and transmission line repair and cleanup work. PIKE is a perennial market laggard with a mid-single digit ~7x EBITDA multiple.


KEY CONSIDERATIONS: INDUSTRIAL SERVICE
This is a fixed asset services / maintenance business in contrast to Field Services, which is a mobile business. Maintenance / industrial services at refineries, chemical plants, oil sands facilities, pulp and paper mills, and other industrial facilities cleaning such as high pressure chemical cleaning, catalyst handling and decoking + lodging / drill camp accommodations in the oil sands

Good proxy for the business – lodging and oil sands industrial services – is CE Franklin, which National Oilwell Varco acquired in 2012 for ~8x EBITDA. I also look to TISI and URS / Flint Energy Services as comp.

Headwind as per negative news out of TISI >> “The revised guidance reflects disappointing results in Team's historically weak third fiscal quarter due primarily to lower than expected revenues from its Canadian and European business units as well as a now anticipated slowing of business growth in the fourth quarter due to the expected timing of large turnaround projects.”

Also, the headwinds to the oil/gas services business outlined above will negatively impact this segment going forward.


KEY CONSIDERATIONS: OIL / GAS SERVICES
Fluid handling, rentals, exploration, mapping, directional boring
Many many headwinds …
New entrant >> Why would anyone use them for this???
Rig counts negatively impacted by low natural gas prices
Political issues around XL pipeline
Heavy competition and pricing pressures

HEK results >> “As expected, the industry related to our shale business slowed in the second half of 2012, particularly during the fourth quarter. Activity declines exceeed normal seasonal factors, which we believe was a function of drilling efficiencies pulling our customers’ capital expenditures forward in the year. Working closely with our customers, we planned for this pullback and reduced our capital expenditures, which totaled $11.8 million for the second half of the year, and in turn were able to grow our cash position in both the third and fourth quarters.”
SAFETY KLEEN ACQUISITION
12/28/12 CLH acquired SK for ~$1.3B cash utilizing $300M cash on hand + $370M from equity offering financed the purchase through a combination of approximately $300.0 million of existing cash, $370M from 6.9M share equity offering ($56/share) and $589M from a private debt offering of 5.125% sr unsecured notes (due 2021).

SK acq valuation reflected 7x annualized 2012 EBITDA of $190M.

SUMMARY THOUGHTS
Inputs to re-refined oil now a cost vs a revenues
Regulations lead to shift to lower margin aqueous cleaning market as solvents legislated out
Re-refining shifts model to higher volatile earnings
Have been here before? Laidlaw acquired the original Safety-Kleen business in May 1998, combining the collection and processing infrastructure of the original Safety-Kleen business with Laidlaw's waste disposal assets (landfills, incinerators, etc.). The proposed financial and operational benefits of the merger were never realized. As a result, in June 2000 our predecessor company filed for Chapter 11 bankruptcy protection.

Business Overview
SK is hq’d in Richardson, TX and is the largest re-refiner and recycler of used oil in North America and a leading provider of parts cleaning and environmental services to commercial, industrial and automotive customers. Prior to the acquisition, SK reported two segments

Segment 1 = Re-Refining.
SK owns and operates two oil re-refineries. One, in East Chicago, IN, is the largest in N. America and the other, in Breslau, ONT is the largest in Canada. These two facilities represent approximately 60% of the total oil re-refining capacity in North America.

In 2012 the company collected roughly 200M gallons of used oil and refined roughly 160M gallons. It recently completed a 10M gallon expansion at the Breslau facility, which cost $30M in CAPEX ($3 / gallon) and a third 50M gallon / $100M ($2 / gallon CAPEX) facility is in the development stages, proposed for the Gulf Coast and expected to complete in 1H15. >> CFO SAYS THIS WON’T HAPPEN; THEY ARE NOT BUILDING THIS

Over the last two years, SK generated roughly $0.70 EBITDA / gallon of re-refined oil. This is below the industry target (as per recent article see below).



Re-refining is largely a regional and commodity business driven by proximity to inputs (used fuel oil). Competitors include Evergreen Oil, Inc., HCCI (Heritage-Crystal Clean, run by former SK executives and pure play publicly traded re-refiner) and NAL.T (Newalta Corp.)

Volume capped by capacity. Price driven by commodity prices. “Re-refined prices and margins correlate with movements in the Independent Commodity Information Services—London Oil Reports (ICIS-LOR) rate, which is quoted weekly for base oil in Europe, Asia and North America. Higher ICIS-LOR yields higher price and margin. RFO price is affected by changes in the US Gulf Coast No. 6-3% oil index (“6-oil index”), which measures the price of heavy fuel oil. Higher 6-oil index yields higher RFO price and margin.”

Segment 2 = Environmental Svcs.
These are mobile operations / services around the fixed based of re-refining. These mobile operations include: parts cleaning, containerized waste services, RFO. This segment includes the costs of collecting reused oil.

Parts cleaning. Both solvent and aqueous cleaning. Business is transitioning towards aqueous cleaning, which reduces amount of waste to landfills. Company has exposure to aqueous work through a 50% JV with Dwight and Church. We recycle all of the used mineral spirits solvent that we collect from our parts washers and return it to our customers as clean solvent, which accounts for more than 60% of our solvent servicing requirements and we believe provides a cost advantage relative to the use of only virgin solvent for parts washer servicing. We dispose of all of the used aqueous fluid that we collect through various disposal channels.

Containerized waste services / Oil collection. “While in the past we have charged customers to collect and remove their used oil, with increases in oil commodity prices, most customers now require us to pay them for their used oil.”

Recycled Fuel Oil (RFO). Revenues from RFO represent direct sales of RFO to external customers. Movements in the price of RFO are generally correlated with movements in the 6-oil index. == U.S. Gulf Coast No. 6—3% oil index, measuring changes in the price of heavy fuel oil.

Total Project Management. Revenues from total project management represent fees charged for various services provided to our customers, such as chemical packing, on-site waste management, remediation, compliance training and emergency spill response or for the service of selecting and managing pre-qualified third party contractors or internal staff to provide such services. Fees charged are generally based on the duration of the project and the materials provided for the project.

Other Products and Services. Revenues from other products and services, such as degreasers, glass cleaners, thinners and hand cleansers and vacuum services represent sales of the relevant products and fees charged for the relevant services.