Harsco: Softening Steel Volumes & Weak Waste Treatment Margins

Very little has gone right for Harsco (NYSE:HSC) in 2022, as the company’s steel services business has seen weakening volumes and the Clean Earth waste treatment business has crumpled under the weight of cost inflation (also an issue in the steel services business). On top of that, there’s little visibility at this point on the sale of the Rail Services business, which management has been treating as a discontinued operation.

I was concerned about the possibility of further margin struggles at Clean Earth back in March, and the shares have lost about half their value since then. There aren’t really any comps for the company, but I would note that Alcoa (AA) and U.S. Steel (X) have seen similar declines over that period, and the waste management space hasn’t been especially strong either.

At this point, I’m torn between a difficult outlook for the steel industry, a more challenged outlook for the economy in general, the company’s self-help initiatives, and the valuation. The shares do appear undervalued on what I think are conservative expectations, but it’s hard to have much confidence in a bullish call here.

Some Signs Of Improvement In The Third Quarter

Harsco did manage to beat lowered expectations in the third quarter, and there were some encouraging performance metrics relative to the prior quarters this year.

Revenue rose less than 4% as reported, and closer to 9% in constant currency. The Environmental business (the steel services business) saw a 2% decline in revenue on a reported basis, but 7% growth in constant currency terms (about three-quarters of this business is outside the U.S.). The Clean Earth business grew 11%, as the company benefits from increased economic activity (which correlates with greater waste volumes) and improved driver availability.

Gross margin declined almost a point to 19.3%, and input cost pressure remains a significant challenge. Adjusted EBITDA rose 3%, with margin holding steady at 14.4%, as Environmental saw a 9% decline (margin down 160bp to 19.1%) and Clean Earth saw a 33% rebound (margin up 250bp to 12.7%). The company began a significant profit improvement plan for Clean Earth earlier this year to combat the impact of cost inflation, and the sequential improvement in margin (from 2.3% to 12.7%) was an encouraging turnaround and the best quarter for EBITDA margin since the first quarter of 2020.

Operating income rose 10%, with margin up 50bp to 6.2%, as Environmental declined 21% (margin down 210bp to 8.3%) and Clean Earth rebounded 70% (margin up 270bp to 7.7%).

Environmental – Strap In For A Bumpy Ride

Steel demand has been weakening for several months, and combined with higher input costs (especially energy), it’s squeezing metal spreads to a point where many steelmakers are curtailing production. As Harsco’s Environmental business is a volume-driven business, this is an issue.

Based on prior management disclosures about the geographic revenue mix for the segment, I estimate that Harsco’s underlying weighted regional production volumes declined around 8% to 9% – considerably worse than the 2% global production decline in the third quarter. The main difference is that production was relatively stronger in the Asia-Pacific region, where Harsco has relatively less exposure. At the same time, average nickel prices were about 15% to 20% higher during the quarter, and nickel is a significant driver of segment performance. All told, high single-digit underlying volume declines and high-teens pricing, with better ecoproducts sales volumes also in play (revenue up 12%) at least roughly corroborates the 7% revenue growth rate.

At this point I’m concerned about the outlook for the business over the next year or so. Steel capacity utilization is now below 70% in the U.S., EU, and Brazil, and I don’t expect a meaningful rebound given weakening end-user demand. With that, Harsco is likely looking at minimal underlying volume growth in the near future with elevated operating costs still present.

One external item of note – the company’s largest rival, Phoenix Services Topco, filed for bankruptcy in late September. I find this interesting as Phoenix competed rather aggressively with Harsco in years past for steel service contracts, and a key part of the Harsco story in recent years has been the company’s decision to restructure the business and walk away from underpriced contracts. While I expect Phoenix Services Topco to try to use the bankruptcy filing to renegotiate its contracts, Harsco could pick up some incremental business.

Clean Earth – Is The Bottom In Now?

Harsco took a big writedown on Clean Earth with second quarter earnings, and also launched a significant effort to mitigate the impact of ongoing cost inflation on the business. Management hasn’t gone into explicit detail on what the program entails, but it does include efficiency initiatives meant to reduce spending on transportation, procurement, and containers, as well as pricing actions meant to pass on the higher costs to customers.

Management didn’t discuss the impact of price (or the price/volume mix) with third quarter earnings (nor in the 10-Q), but I would imagine that price played a role in the 9% quarter-over-quarter acceleration in revenue, as well as the stronger margins. I’d also note that, despite a contract that is supposed to afford Harsco/Clean Earth the right to pass on these costs, Harsco has had to file litigation against Stericycle (SRCL), a significant customer as part of this process.

Clean Earth remains a difficult business to assess. I like the idea of a business with high barriers to entry and growing demand (particularly with increased attention on pollutants like PFAS). Not only have chemical, industrial, and healthcare companies been seeing greater activity in recent quarters, Clean Earth is also leveraged to growing infrastructure activity (roadbuilding, bridges, et al) and ongoing growth in personal electronic devices (and their batteries). Much further down the line, as electric vehicles become more commonplace and face the end of their service lives, I would expect battery disposal/recycling to be a significant opportunity.

On the other hand, the business has had one problem after another since Harsco acquired Clean Earth from Compass (CODI) and ESOL from Stericycle. Nobody saw the pandemic coming, and its sharp, sudden decrease in volumes, but the company has struggled to find and keep drivers and control costs/generate leverage ever since. Even if Harsco can deliver a 10% sequential improvement in Clean Earth’s EBITDA in the fourth quarter, that still means the company paid about 15x FY’22 adjusted EBITDA to get into this line of business.

The Outlook

While Harsco’s revenue has actually remained more or less on track relative to my initial expectations for the year, margins are coming in considerably lower. With that, and considering management’s guidance, I’m looking for around 2% revenue growth this year, slightly weaker growth next year (on weaker conditions in steel production and the economy at large), and around 3% to 4% long-term growth.

With margins, I’m expecting a little under 12% EBITDA margin in FY’22, climbing to 14% in FY’24. Management is still targeting 15% long-term margin, and I think they can get there, but I need to see more evidence that the margin improvement efforts in Clean Earth are durable before getting too bullish on a faster ramp (I had previously expected 15% EBITDA margin in 2023).

I’m now looking for long-term FCF margins in the mid-to-high single-digits, which combined with the revenue growth I expect should drive FCF growth in the high single digits.

The Bottom Line

Both discounted cash flow and a margin/return-driven EV/EBITDA approach (which supports an 8.25x forward EBITDA multiple) suggest Harsco is undervalued, and I don’t think my modeling assumptions are all that aggressive. Granted, the steel sector could see even greater volume weakness than I expect and the margin/cost improvement efforts at Clean Earth could fail, but those are part of the operating risks that go with this name.

My biggest issue now is basically just a lack of confidence in the macro outlook and in the company’s ability to execute. Clean Earth has been a drag almost from the beginning and management has to prove to investors that it’s still a value-building business, and all of that is shadowed by a high level of debt. I can definitely understand the appeal here for contrarians, but I don’t need or want this kind of risk in my portfolio today.