What Stericycle's Management Wants You to Know About Its Q3 Performance

By Markets Fool.com

It's been a rough year for medical-waste disposerStericycle (NASDAQ: SRCL), whose stock has tumbled more than 33% in 2016, thanks to two disappointing quarterly earnings reports, the revelation of an accounting error that overstated 2015's earnings, and lowered 2016 earnings guidance.

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But the company beat earnings estimates in its third quarter. Although managementwas pleased, it nevertheless predicted a less-than-rosy outlook for the future. Here's what investors need to know about what's next for Stericycle.

Stericycle hopes to grow by cross-selling services to existing clients. Image source: Getty Images.

Cross-selling out of a crunch

One of the hot topics during the Q&A portion of the call was "SQ pricing." Stericycle divides its waste-disposal customers into two groups: "large quantity" (LQ) and "small quantity" (SQ). Large-quantity clients generate, naturally, large quantities of waste and include hospitals and blood banks. Small-quantity clients tend to be smaller operations, such as doctors', dentists', and veterinarians' offices, or outpatient clinics.

The vast majority of Stericycle's revenue -- 75% to 85% -- comes from SQ clients, which generally are higher-margin customers.However, during Q3, the company experienced "pricing pressure" from these clients, leading to lower margins. For the year, SQ revenue growth is expected to be only 3%-5%, compared with LQ's 2%-3%.

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The analysts wondered, naturally, how the company was planning to handle this SQ pricing pressure problem. Analyst Kevin Steinke of Barrington Research wondered if the company had tried cross-selling some of its other products to the SQ clients. COO Brent Arnold responded:

As we talked about on our last call, we were making a number of investments, both marketing and sales, to try to offset some of those headwinds that we are seeing. ... We've got more sales reps that have been hired, and we're working to have them have a bigger impact with regard to influencing that renewal, emphasizing the value of our Steri-Safe services, and overall trying to approach that situation proactively. Obviously it's too early to see any returns on that, but that is definitely one of our strategies, as well as trying to grow new sites in SQ is another strategy, too. While it won't offset that headwind, it will drive new growth that in turn will help us offset that in the long term.

Analyst David Manthey from Baird followed up on this point, mentioning that historically, more than half of the company's organic growth comes from cross-selling services. Alutto indicated that the cross-selling was likely to be even more important in 2017:

[G]iven the pricing pressure that we face, especially in our SQ business ... we would estimate that about 20% of our growth will come from price and volume and about 80% from additional services.

That sounds as if the company is putting a lot of its eggs in the cross-selling basket. Given that pricing pressures are holding down margins,it probably has no other choice, but investors should be aware that the company's growth projections hinge on its ability to successfully cross-sell its products such as document shredding to its waste-disposal clients. With Shred-It being such a new acquisition, though, there's no guarantee of how successful those efforts will be. And even management indicates that these efforts will take time to bear fruit.

A middling future

If there was ever an "uh-oh" statement to hear from a CEO, it was this one from Alutto on the earnings call:

Stericycle continues to be the market leader in multiple services and geographies. We have a strong team and an unmatched infrastructure. We are confident in the long-term outlook of our business.

When a CEO talks about how confident he is in the company's "long-term outlook," it's often a sign that the short-term outlook isn't so hot.

That's definitely the case with Stericycle. The company isn't predicting much growth -- if any -- in EPS for 2017. On the call, Alutto reiterated the company's 2016 adjusted EPS guidance of $4.74-$4.76, which includes "the benefit of our ongoing strategy to repurchase the mandatory preferred convertible shares" issued as part of the Shred-It purchase. However, for 2017, Alutto is predicting only $4.57-$4.77 in EPS, which means that unless the company comes in at the top end of its 2017 guidance, it's likely to see EPS declines in 2017. This should raise a red flag for potential investors.

The rationale

In response to a question from analyst Hamzah Mazari of Macquarie Capital, CFO Dan Ginnetti added more context about the company's 2017 guidance. At the midpoint of the EPS guidance, he expects operating margins to be flat compared with 2016. He further elaborated:

Certainly you have the synergies that will be only partially offsetting the price concessions we'll have next year. And then the growth: It doesn't come through at the same percent that pricing goes out.So you're going to see a little bit of pricing there on profitability headwinds.

We are also going to be experiencing some effects exiting a patient contract. That can temporarily affect margins until you're fully out of that. And then we are going to make investments in the business, and that's important that we do that. ... But initially at the beginning of the year, those investments will really be investments to set out the infrastructure in that stage to be able to grow the business, so that's going to be some of the headwinds.

While it's good to have this additional context, flat margins and negative EPS growth are not going to be good for investors.

Investor takeaway

Based on management's statements on the earnings call, it doesn't sound as if 2017 is going to be a good year for Stericycle investors. The company is guiding for probable negative EPS growth, with flat operating margin. What revenue growth there is, is expected to come 80% from cross-selling its services, but according to management, it may take several years for those cross-selling efforts to take off, if they take off at all.

Given all this, investors should probably steer clear of Stericycle until its future looks brighter.

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John Bromels has no position in any stocks mentioned. The Motley Fool recommends Stericycle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.