Why you need to avoid these two environmental services companies

Ethical investing has become more popular over time, but just like any investing strategy, investors can’t just invest in every company that appears ethical.

I’d certainly love to invest my funds in companies that provide products or services that help the environment, and I’ve had my eye on these two companies for many years.

Unfortunately, neither is investment grade for a number of reasons – despite their essential services to society.

In a number of sectors, companies can achieve economies of scale by growing organically and via acquisitions. What that means is that as a company grows, it can reduce its costs, and increase its margins. Both these companies have attempted to grow this way, but so far the results are less than stellar.

Tox Free Solutions Limited (TOX)

Billed as safe.reliable.sustainable, Tox Free has made a multitude of acquisitions over many years in an effort to gain scale and those synergies to increase margins and profits. Since listing on the ASX in 2000, the waste management and industrial cleaning company has delivered an 11% loss to shareholders, despite paying dividends since 2010.

Rather than realise benefits from those acquisitions, Tox Free has seen its return on equity sink below 10%, as the number of shares surged from 63 million to 524 million, before an 8 to 1 consolidation in 2006 slashed the number of shares back down to 66 million.

Those shares were mostly issued to make acquisitions, and the company was at it again earlier this week, raising more equity for a $70 million acquisition. Total debt was also more than $90 million at the end of December 2015, and that will jump ever higher, with an expected $50 million of new debt used to finance the most recent acquisition.

Unfortunately, Tox Free’s history suggests that this acquisition is unlikely to materially change the fortunes of the company – despite management’s forecast of a 13% increase in earnings per share.

Along with funds spent on making acquisitions, Tox Free is also highly capital intensive. Despite reporting a first-half net profit of $12.6 million, the company expects to spend $23-$25 million on capital expenditure.

Cleanaway Waste Management Ltd (CWY)

Like Tox Free, Cleanaway is a waste management company, and it operates a network of collection, processing, treatment and landfill assets, not to mention more than 2,500 trucks (many are your local garbage trucks) around Australia.

But it too has followed the buy to build scale strategy – which hasn’t worked for Tox Free, and so far hasn’t worked for Cleanaway either. Since listing in 2005, shareholders have seen a -71% return on their investment.

Like Tox free, there’s been a massive increase in shareholders equity (~10x), but earnings and cash flow have gone backwards, revenues have remained fairly static over the past five years, debt has increased, profits are inconsistent, one-off expenses and writedowns are a frequent occurrence. All of that suggests that the company’s strategy of growth via acquisition has failed. Cleanaway has ended up with $1.5 billion of intangibles on its balance sheet, and $360 million of debt (partly offset by $35 million of cash).

Cleanaway is also highly capital intensive. From operating cash flows of $77.8 million in the first half of FY2016, the company spent $70 million on capital expenditure – and that appears typical.

Foolish takeaway

When companies have to spend so much of their incoming cash flow just to maintain their operations – that leaves little scope for the company to be able to invest in growth – unless the company raises equity or borrows more from its bankers.

Unless Tox Free and Cleanaway can find better ways of growing organically, their financial performance is hardly likely to improve much, and neither will the share price.

Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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