Sharps Compliance (NYSE:SMED) collects and disposes of medical waste; this includes everything from unused medication to used syringes. SMED has received tailwinds from COVID as the vaccines have effectively doubled their medical waste from its two biggest clients, Rite Aid and CVS. We believe SMED is an interesting and simple candidate to research as part of our dive into the waste industry as there are only two medical waste players- Stericycle and SMED. This duopoly is dominated by Stericycle, the 1000 lb gorilla which has revenues 20x greater than that of SMED.. However, Stericycle has been accused of almost criminal price gouging and had to pay roughly 300mm in a lawsuit brought against it by thousands of customers. This negative goodwill was then compounded by Stericycle diversifying into multiple other industries, leading to classic shareholder destruction and significant debt. Stericycle has recently brought in new leadership to right the ship and divest non-core divisions, all while paying down debt and reducing prices for its medical waste customers. Stericycle’s operational mishaps and bad reputation have helped open the door for SMED. SMEDs strategy for the past few years has been around expanding its relationship with CVS and Rite Aid along with winning smaller fragmented waste routes for small businesses and assisted care facilities. The likelihood of new entrants entering this industry is low even though the start up costs are minimal as the lengthy permitting process is a large barrier to entry and it would take years for new competitors to begin operations.
SMED has two waste facilities located in Texas and Pennsylvania. These include 1 hazardous waste incinerator and 4 autoclaves. SMED primarily uses its own truck drivers or subcontractors to collect medical waste and then either routes that waste to its facilities or third-party facilities. SMED’s waste is usually one of the following: Medsafe liners ( mostly unused medication), syringes used in retail locations (CVS/RiteAid) for flu/covid vaccines, and single-use medical devices. SMED has over a 70% market share in medical waste and used syringe disposal at retail locations thanks to its crown jewel relationships with CVS and Rite Aid (they are responsible for roughly 45% of revenues for SMED). SMED has installed roughly 3k Medsafes at these retail locations. SMED pioneered the Medfe business back in 2015 now has almost 7k installed throughout the USA. These provide a recurring revenue stream as a Medsafe is just a special trashcan that is used for medical waste. Even more, the convenience of these Medsafes causes people to use them more as habits get ingrained.
One can see this in the number of liners per Medsafe that get disposed of. The liner usage has grown at about a 65% CAGR since 2015 while the number of Medsafes has only grown by about a 35% CAGR. These high-margin Medsafes generate about 1k in revenue per year. SMED believes the TAM between retail locations and assisted living centers is about 100k potential Medsafe locations, giving SMED about a 7% penetration and a lengthy runway. The only other competitor in the space is Stericycle which has roughly the same amount of Medsafes however is more focused on hospitals and larger waste facilities.
SMED’s other significant business segment is Mailback. Mailbacks are specialized packages that are mailed from the customer location to the waste facilities. Typically, this is done for items such as vaccines- the customer puts the used hypodermic needles in a sharps containers and mails them to SMED waste facilities. SMED received roughly 54 mm in revenue from providing this service in 2020, an almost 100% increase from the prior year due to the novel COVID vaccines.
SMED has grown revenues at around a 10% CAGR since 2015 (excluding the large one-time bump from COVID) and we expect this to continue for the next several years as it expands its customer reach and acquires other smaller waste haulers. SMEDs incremental revenues have high gross margins (>40%) as SMED has already invested in the large fixed costs at their facilities. We expect these high incremental margins to continue as there is significant headspace available for higher throughput, SMED is currently running at about 35% capacity as seen below.
To increase their share further, SMED is looking at tuck-in acquisitions. These acquisitions are highly profitable as SMED can consolidate costs such as the driving routes using their own drivers. However, the combination of the right price and willing sellers is hard to find. In the past 5 years, SMED has completed only 2 acquisitions out of a large pipeline( the aggregate revenue of all these potential targets is almost 200 mm dollars). Below SMED CEO David Tusa laid out what they look for in an acquisition at the 2015 annual conference call :
“… good management, they’ve got to have a solid customer base. And I’ll just tell you right now, if they’re $1 million to $3 million in revenue, the first thing that we look at is, “Okay, is it a 40-plus percent gross margin? Is it a 20-plus percent EBITDA margin?….”
To recap:
-Good management
-1 to 3 mm in revenue
-40% gross margin & greater than 20% EBITDA margin
-Preferably have their own waste treatment facility
We believe SMED has sound capital allocation in regards to acquisition targets (although not in how they fund these acquisitions) and SMED would represent a much better opportunity if candidates wanted to sell. Unfortunately, as these smaller businesses are family-run or do not want to sell at the multiples SMED is offering, acquisitions have not been a strong growth driver for SMED and will likely stay this way.
Risks & Headwinds
Roughly 45% of SMED’s revenue comes from two customers (CVS and Rite Aid). Although these have been loyal customers for the last five years, we would have a lot more faith in SMED’s ability to retain customers if not for Stericycle winning Walgreens away from SMED four years ago. This will be a perpetual risk and is hard to quantify.
SMED has diluted shareholders this year in order to fund acquisitions by issuing close to 20mm dollars worth of stock. This was a bit of a head-scratcher as SMED already had significant cash, had no large acquisitions in the pipeline, and could’ve used debt financing. Although CEO Tusa owns a significant amount of stock (roughly 3 million dollars worth), more share dilution is a potential risk.
Catalysts & Tailwinds
SMED has been positioning itself as the go-to Medsafe provider for home healthcare and assisted living. Given the fragmented nature of these businesses, getting large business contracts is almost impossible. However, as these businesses consolidate, SMED could start entering contracts large enough to move the needle.
Valuation
Prior to COVID, SMED had been growing at about a 10% rate for the last several years through a combination of its Medsafe business and expanding its mailback business. We believe they can maintain this growth rate for the next several years. Incremental gross margins from these businesses are roughly 40% and after factoring in SG&A, net margins come out to be around 10%. After taking into account maintenance capital expenditures of around 1-2mm/ year, SMED will be throwing off about 12mm in cash by 2025 (This is after giving SMED an additional 8mm in revenue per year from COVID vaccines, roughly equivalent to their flu vaccine revenues). Although SMED’s business is consistent and fairly recession-proof, it derived almost half of its revenues from two customers. Paying about 10x 2025 earnings for a company practically in a zero-sum industry with a much larger competitor is leaving a low margin of safety. We believe fair value is closer to around five dollars per share. We will not be a buyer at these levels however if there is a significant pullback, we will look to initiate a position in SMED.
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