Clean Ports: Continuous Reinvestment Runway to Redeploy Free Cash (NYSE:CLH)

Investment update

After my last piece on Clean Harbors, Inc. (NYSE:CLH) the stock is up +36% and there have been some significant changes in the investment debate. Coming back to my original thesis, I was drawn to CLH for several reasons, namely:

• A top-down strategic allocation indicating an allocation to the Industrials sector given the attractive risk/reward fundamentals in the sector (it was expected to provide ~16% upside to S&P 500 earnings over the coming 12 months, but at the time had a par value of just 8%).
• Management remains focused on generating freely available cash flow, with continued growth in reinvestment of additional capital.
• Over the last 1, 3 and 5 years, the company has methodically turned profits into FCF growth at ~18%, respectively.

These trends are fully visible in CLH’s Q2 FY2024 results and my conviction on this matter name remains in situ as well. This report will provide the latest updates for your own investor reasoning. Net-net, continue to evaluate buy.

Profit distribution for Q2 fiscal year 2024

CLH achieved Q2 revenue of $1.5 billion (+10.7% YoY) with adjusted EBITDA of $328 million, compared to $287 million in the prior year, continuing long-term sales + earnings growth (Exhibit 1).

Figure 1.

The division breakdown is as follows:

• Environmental Services segment grew 12% year-on-year thanks to initial revenues from HEPACO acquisitionn – Management said the acquisition accounted for ~50% of the total revenue growth in the segment. The remainder was driven by volume and pricing. Incinerator utilization was reported to be 400 bps higher year-on-year at 88%, with average realized prices up +300 bps. This was supported by a 400 bps increase in landfill tonnage. Meanwhile, the Technical Services business grew 14% year-over-year as record drum volumes were collected.

• The Safety-Kleen division recorded year-over-year growth of 11% driven by higher volumes. Growth has been underscored by demand for container waste disposal. This could be a tailwind for this segment going forward, but I think it’s the environmental services business that deserves the most attention at this point in the cycle.

In relation to a potential deal with Castrol management discussed on last quarter’s call, the company stated in the second quarter call:

Last quarter we discussed our long-standing partnership with Castrol and its more circular program. Castrol officially launched the program at the end of May at a key transport industry trade show.

They have been putting in a significant marketing effort since announcing the program in two dozen media outlets (unidentified) and key publications. While we can’t share details on sales progress, we can confirm that they are building a pipeline of interest among a number of large fleet operators.

Our multi-year agreement with Castrol as our sustainability partner is a strong endorsement of the high quality of our refined base oil.

As a talking point, management says it is in a great position to execute its Vision 2027 program. This is a good sign and the fact that it is focused on a mix of organic growth, acquisitions, debt servicing and share buybacks, all “driven by ROIC,” should not be overlooked in my opinion.

Given the relatively strong performance this quarter, management has revised its guidance upwards to $1.16 billion in pretax income at the high end of the range. That looks set to generate $426 million in profit, a double-digit increase over previous guidance. The main driver of growth is the acquisition of HEPACO, which management expects to generate $35 million in pretax profit this year.

It looks to be burning ~$350-$400 million in free cash flow, which I think is extremely attractive because 1) that translates to ~30% of pre-tax earnings and 2) provides excellent opportunities to redeploy cash to meet capital allocation goals. In my opinion, this was a strong quarter that continued management’s long process of redeploying funds back into the company at high marginal rates of return. This tells me that new investments are performing better than older assets, which I think is very supportive of a long growth run.

Figure 2.

Valuations Supporting Future Growth

One of the standout features of this debate is management’s propensity to return most of its cash profits to the business in order to increase purchasing power. In Figure 3, we can see this trend from 2021 and the corresponding growth rate in incremental profits (note the black line shows profit growth, not actual cumulative or printed profits for the period, where profits are net operating profit after tax). The point is that CLH is capitalizing capital at high marginal rates of return.

Figure 3.

Valuation Notes

• The market certainly respects this aspect and has increased the valuation multiple of the business from 1.4x to 2.5x at the time of writing. Every dollar that management retained and recycled back into the business by increasing the capital base was valued at $6.80 by the market. As a result, management invested ~$1.3B in business development, which generated over $8.7B in additional market value.

Figure 4.

• The question is whether these trends will continue and whether this valuation multiple will hold. To achieve this, the company has had to generate high marginal rates of return on incremental investments – in other words, it has had to reinvest in new projects that generate high incremental earnings growth. My revised assumptions (see Appendix 1) predict a 29% increase in earnings power by FY2026E, which could result in a market valuation of $245 per share.

Figure 5.

• Management is expected to reinvest about 20% of cash earnings each year and generate up to a 32% marginal return on those investments. That’s a high hurdle, and the implicit expectations are equally high at current valuations. So there’s a risk that management doesn’t live up to those high expectations, which could result in investors paying less dollar for dollar of invested capital in the business, or that the stock is less likely to appreciate given that.
• As such, I believe CLH is well-positioned to continue to reinvest freely available cash into its core operations and/or acquire profit-generating businesses with the aim of growing earnings at a statistically significant rate over the next 2-3 years.

Figure 6.

Risk to the thesis

Downside risks to this thesis include 1) management not committing any funds to investing in the business, instead opting to return all capital to shareholders because it depresses valuation, 2) revenue and growth rates falling below 5% for the same reasons as above, 3) regulatory changes that impose a symmetrical burden on the industry or company, 4) broader macroeconomic risks that now need to be considered, primarily the inflation/interest rates axis, as well as geopolitical risks that could potentially spill over into broader equity markets.

Investors must be fully aware of these risks before taking any further steps.

In short

CLH remains a buy in my opinion, given 1) the long reinvestment period, runway management needs to redeploy surplus funds to its advantage, 2) the business advantages are hard to replicate, which provides lower friction growth ahead, and 3) the business economics justify higher prices at current valuation multiples. Repeat buy, targeting $245/share.

Annex 1.