Wednesday, January 1, 2014

Arbitrage with Sterihealth and Stericycle

Recently, I was thinking new places to look for smallcap gems, and I decided to try Australia. There I found a candidate with a colorful past.

The company is Sterihealth (STP:ASX). It deals in hazardous medical waste disposal. The company was known in 1999 as Cutters Ridge Resources. I guess it's business in resources was a failure so the company's management decided to change the company name to Stericorp and try the medical waste business. However, it appears that the management initially didn't know the business.

The company initially tried waste disposal in Argentina, which failed. Then they bought a plant from Stericycle (SRCL:NASDAQ) in Canberra, Australia, but that was also written down to zero in 2004. Then in 2005, with new CEO Daniel Daniels, Stericorp sued Stericycle for breach of contract to try to recover some of the losses. They eventually won $18 M in that suit. I think the company has stablised with Daniels at the helm. Stericorp turned over a new leaf by changing its name to Sterihealth and it bought 100% interest in ADX, a company started by Daniels.

I think it is interesting to compare Sterihealth and its much bigger former partner Stericycle. The two are both in medical waste, but Sterihealth only operates in Australia while Stericycle is a global player. The following table shows their stats.

In my view medical waste is a profitable and growing industry. Companies in the industry should easily earn returns above their cost of capital. I think that is why Stericycle commands a 37x earnings multiple. But Sterihealth couldn't be more different, it trades at only 6.6x earnings! So, does this mean Sterihealth is a severely mispriced stock? The company history should give some clues.

The company has had a troubled history up to 2005. At that time, the stock reached less than $1 from a high of around $12, and for good reason. The company had accumulated losses of more than $30M! By 2006 they had turned a corner I feel with the new CEO and had raised $15M over three years to shore up the balance sheet. By 2007 Sterihealth got another $18M from settling with Stericycle. The following shows the company's earnings.

Sterihealth Earnings (Mil $ AUD)

Note, that the above results excludes the one-time $18M gain from the Stericycle settlement. So, one can see the company is in a good industry with consistently growing revenue. Therefore, I think the company deserves a higher multiple. Or, looking at it another way, the earnings multiple of Stericycle and Sterihealth should not be as dramatic as it is today. Stericycle must either fall or Sterihealth must go up, or both.

I am long Sterihealth.

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