It may not be a glamourous business but it is a good one.
Pricing emanates from disposal operations – that’s what industry experts say. Waste has to go somewhere, and therefore whoever has the disposal operations sets the bar with respect to pricing from transfer facilities all the way through collections. After all, garbage pick-up operators won’t be in business for long if they pay more to dispose of waste than they charge to pick it up. Industry economics in the waste industry are relatively easy to understand.
As for the players, Waste Management (WM) and Republic Services (RSG) have the largest disposal operations in the US. At the end of 2014, Waste Management owned or operated 252 landfill sites, the largest network of landfills in the country. That number stands at 189 for Republic Services and 58 at number three, Waste Connections (WCN). These players dominate the municipal solid waste industry and will for some time to come. We view disposal pricing as having oligopolistic tendencies, even if collection operations face some of the most intense pricing competition of any industry.
Let’s first start with our concerns. For those that remember Allied Waste, which was bought by Republic in mid-2008, early last decade the company suffered from significant underinvestment of its truck and equipment fleet as it was saddled with debt from its acquisition of Browning-Ferris in 1999. We’ve always been of the debt-averse persuasion, even for steady-eddy businesses like those in the waste industry, which are often more cyclical than many observers understand. For one, roll-off volumes, which can be as much as one third of collection operations, ebb and flow with the construction cycle, while commercial collection is tied to business formation and health.
Regardless of how recession-resistant the waste industry may be, net debt is still something worth watching closely. At Waste Management, net debt stood at $8.83 billion at the end of the second quarter of 2015, while that mark stood at $7.45 billion at Republic Services. Waste Connections is a much smaller player, but it, too, holds a net debt position of about $1.96 billion at the end of March 2015. Granted, it is not the size of the debt load that matters, but whether a company has the capacity to continue to service it, but leverage can have significant implications on a company’s share price during the trough of the economic cycle and especially during periods of tightening credit conditions. It should not be surprising that companies with the highest levels of leverage suffer the worst during challenging economic and credit conditions.
That having been stated clearly, it’s fantastic to see industry players maintaining discipline as they collectively push prices higher. In Waste Management’s second-quarter report, the firm noted that core price expanded 4.1%, while in the same quarter, Republic Services drove core price 3.8% higher. Such strength translated into an improvement in both firms’ EBITDA margins on a year-over-year basis during the period. At Waste Management, free cash flow increased $245 million in the second quarter of 2015, after excluding proceeds from divestitures in 2014, while Republic upped its adjusted free cash flow guidance for all of 2015, to the range of $720-$745 million (was $710-$740 million). Lower diesel fuel prices are helping and may be here to stay.
We’re often asked why we like Republic better than Waste Management, and the answer is that we like both companies. However, we chose Republic because the firm registered a 9 on the Valuentum Buying Index in July 2012 when it was trading in the mid-$20s per share (it’s now over $40 per share), and we still think the company has a lot of value to extract from the Republic-Allied combination. We don’t dislike Waste Management or Waste Connections for that matter. We just like Republic a bit more, that’s all. As I said of the Republic-Allied deal back in 2008:
“The value of the landfills is going to do nothing but increase down the road,” said Brian Nelson…in Chicago. “Ten years down the road, we’re going to be looking back at this transaction and saying this is a pretty savvy move because of suburban sprawl, because of population growth.”
We continue to like Republic, and while its Dividend Cushion ratio speaks of heightened risk due to its massive debt position, we won’t be disposing of this Best Ideas Newsletter portfolio holding anytime soon. Don’t expect huge returns from this idea, but Republic Services remains our favorite play in the waste industry.
Environmental Services: CLH, CWST, DAR, ECOL, RSG, SRCL, WCN, WM