Waste industry economics are relatively easy to understand. Municipal solid waste has to end up somewhere, and therefore whoever has the most diverse disposal operations can set the bar with respect to pricing, which impacts tipping fees and the economics of transfer facilities and collection operations. 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. We view disposal operations as having oligopolistic tendencies, even if collection operations face some of the most intense pricing competition of any industry.
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), which added multiple tuck-in acquisitions in the third quarter. These players dominate the municipal solid waste industry and will for some time to come.
Both Waste Management and Republic Services reported solid core price increases near 4% in the third quarter of 2015. The companies’ revenue growth from average yield stood at 1.8% and 2.5%, respectively. Republic Services added slight volume growth to arrive at total revenue growth of 3.4% and total revenue of $2.3 billion in the third quarter. Waste Management was the only one of the three to report revenue falling in the quarter, as asset sales and recycled metal prices hurt the comparison of reported top-line results; revenue fell by ~6.7% to $3.4 billion. Waste Connections’ core price increased 2.7% in the quarter, and solid waste pricing and volume grew over 5%. The firm reported relatively flat revenue, however, at nearly $548 million due to sharp declines in recycling revenue and exploration and production waste treatment, recovery, and disposal revenue.
The fall in recycled metal prices was an issue throughout the industry. Both Waste Management and Waste Connections reported recycling revenues fell 15% or more from the year-ago period, and Republic Services cited low metal prices as significant headwinds in the quarter. The industry is not unaffected by changing commodity prices, despite the steady quality of the business models of operators within it. Falling commodity prices have also benefited the waste industry, as lower fuel costs helped margins in the third quarter. Waste Management cited fuel cost improvement as the main driver of its 140 basis point improvement in operating income margin, and Republic Services realized benefits to adjusted EBITDA margins as a result of lower fuel prices as well. Waste Connections reported solid waste margin expansion of approximately 200 basis points. The pricing power of the industry continues to benefit margins as well, and this is happening despite lower fuel surcharges.
Though its revenue faced pressure, Waste Management’s margin improvement allowed it to grow earnings per share at the fastest rate of the three competitors in this writing. Diluted earnings per share grew more than 27% in the quarter due to improved operational performance in the period. Significant operational improvements were made in its recycling operations, where revenue fell 15%, but segment income remained flat from the year-ago period. Republic Services and Waste Connections were not able to mitigate the impact of falling recycled metals prices, reflecting the strength of Waste Management’s scale and operations. Waste Connections reported a decline in adjusted earnings per share, and Republic Services reported a 2% increase in adjusted diluted earnings per share in the quarter on a year-over-year basis.
Though we like the operational improvements made in Waste Management’s third quarter, we cannot deny the fact that the company returned more cash to shareholders in the quarter than it generated in free cash flow. It paid $472 million in dividends and share repurchases despite only generating $358 million in free cash flow, which fell by over 14% from the third quarter of 2014. The year-to-date ratio of free cash flow to cash returned to shareholders is much closer to 1 for the firm; Waste Management has flexibility to scale down share buybacks, however. Republic Services and Waste Connections have not allowed cash returned to shareholders to exceed their free cash flow generation thus far in 2015.
Though Republic Services has a slightly smaller net debt position than Waste Management—approximately $7.4 billion and nearly $9 billion, respectively—Waste Management has significantly higher free cash flow generating ability. For the full year, Waste Management is expecting to exceed the upper bound of its free cash flow guidance of $1.5 billion, and Republic Services is targeting $720-$745 million in adjusted free cash flow. Waste Connections has a much smaller debt position, with net debt coming in just under $2 billion. The smaller rival also retains a larger portion of free cash flow than its larger competitors. In the year-to-date period, the firm has generated nearly $300 million in free cash flow, while only returning $140 million to shareholders through dividends and share repurchases.
Though we like all three municipal solid waste operators, Republic Services remains our favorite play in the waste industry. The company holds what we believe to be the crown jewel of the waste industry in its Apex landfill, the largest in the US, in Clark County, Nevada. The barriers to entry in the waste collection industry are significant, and the pricing power that comes from holding significant landfill and collection assets is undeniable. The fact that we like Republic Services more dates back to 2012 and is a cause of our commitment to the Valuentum Buying Index. The firm has registered a much coveted score of 9 in the past, the very reason we added it to our Best Ideas Newsletter portfolio.
Waste Management and Waste Connections are strong companies as well and benefit from the same dynamics as Republic Services. The impact commodity prices will have on the companies will likely persist for some time, and we see no sustainable rebound in crude oil coming in 2016; a significant recovery in metal prices is not looking favorable in the short term either. Nevertheless, Republic Services is expecting solid growth in earnings per share and adjusted free cash flow in the upcoming year. We’re still holding on to this trash taker.
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