Waste Connections (WCN) – “Every Tuesday and Thursday”

Company:         Waste Connections (WCN)
Sector:                Industrials – Waste and Environmental Services
Price/Market Cap:                        $83/$22B
Target Price/Implied Upside:     $107/30%

Thesis
Waste Connections (WCN) is the third largest waste disposal company in North America, and the only company focused on secondary and exclusive markets.  The company has flourished behind the leadership of a seasoned management team focused on consolidating fragmented niche markets where they can streamline operations, exert pricing power, and improve profitability.

  • The only waste company focused exclusively on secondary and exclusive markets.
  • Sector leading conversion of EBITDA to FCF driven by a combination of organic and M&A growth.
  • Superlative track record of acquiring and consolidating fragmented markets.
  • Benefit from the multiplicative effect of price increases supported by GDP based volume growth.

WCN is in the middle innings of a consolidation strategy that will allow them to continue compounding FCF for years to come.  The company offers investors a combination of above industry FCF generation combined with the defensive attributes of the waste sector.  At a stage in the business cycle that forecasts slowing economic growth, the waste disposal sector offers consistent earnings growth at a higher rate than the broader market, with the benefit of much less volatility and fewer earnings drawdowns.

Catalysts

  • Within the fragmented industry, WCN is best positioned to drive consolidation due to their niche focus and market reputation. More than $500M in acquisition EBITDA that aligns with their current asset base remains independent and available[1].

  • Recently completed merger with Progressive Waste Management provides an opportunity for repricing of Progressive contracts that are now coming up for renewal.

Industry
The waste disposal industry is highly fragmented.  More than 50 of the top waste companies each generate over $100M+ in revenue, and then thousands of other private “mom and pop” operations fill the white space. Waste volumes are typically correlated with GDP, population growth, and housing starts.  Population increases lead to higher volumes of trash.

Solid waste is a commodity business where the lowest priced provider wins.  There is a basic level of service expectation from customers and, if you can exceed that hurdle, you can profit. Companies compete at the local level where market share and relationships matter.  The costs associated with a single waste collection trip (driver salaries, fuel costs, and truck depreciation) are mostly fixed. If a company is the market share leader within a specific region, they can gain efficiencies by optimizing trip routes and wielding additional pricing power over municipalities.

Seasonality
There is some seasonality in the waste business. Revenues are typically lowest in the first and fourth quarters and highest in the second and third with expected seasonal fluctuation of approximately 12%.  The seasonality reflects:

  • Lower volume of solid waste generated during the late fall, winter and early spring due to decreased construction and demolition activities during winter months.
  • Reduced E&P activity during harsh weather conditions and higher operating costs in winter months as adverse winter weather slows waste collection activities and increases labor and operational costs.
  • Greater precipitation in the winter increases the weight of collected Municipal Solid Waste (MSW).

Industry Challenges
For years, recycling was cheap as China was willing to accept large quantities of recyclable plastic and other materials on the empty containers returning from delivering iPhones and other goods to the U.S.  Rather than returning empty, why not allow companies to ship their recyclables for a small fee?  This system provided waste management companies a tidy profit on their recycling programs. As commodity costs came down over time, it became cheaper to simply manufacture new plastic from scratch as opposed to recycling from used/dirty materials.  And so, China began limiting the amount or recyclables it would accept.  In January 2018, China effectively banned imports of recyclable material completely.  This development put domestic waste management companies in a bind as their fixed recycling contracts weren’t covering the added costs of recycling and disposal domestically.  The industry has largely offset these headwinds through cost-cutting and new fees such as contamination fees to compensate for the costs of recycling “dirty” plastics and paper.

Solid waste disposal is a price competitive, commodity business. From time to time, competitors may reduce the price of their services to gain market share or win competitively bid municipal contracts. This pricing competition can become a problem when companies begin to act irrationally to the point where they operate at a loss to maintain market share.

Company
Waste Connections was born from the management buyout of the Idaho and Washington Operations of Browning-Ferris Industries[2].   Within a year of its founding, WCN filed for IPO and became a publicly traded company.  From its inception, the company strove to dominate the secondary, non-urban markets located west of the Mississippi. Similar to Walmart’s legacy expansion strategy, WCN avoided large, competitive metropolitan markets, opting instead to build an integrated, clustered presence in the suburban and rural west. The company grew through acquisition with candidates considered for acquisition only if they controlled a leading (first or second) market share in their communities. Management also mandated that the target have access either to their own landfill or to a municipal dump, which allowed the company to avoid dependence on a local competitor for disposal. Finally, Waste Connections preferred to acquire companies with exclusive rights to operate in their market, either through a franchise agreement, a long-term municipal contract, or a governmental certificate. Waste Connections has grown to become the third largest, non-hazardous, solid waste services company in North America. WCN management segments their markets into two categories:

  1. Franchise business markets (43%) – These are primarily domiciled on the west coast. Franchise owners are given a monopoly to pick up trash for a defined geographic area.

  2. Competitive markets (57%) – In these markets, the company controls the garbage disposal as well as the pickup. These markets are attractive in that customers are willing to pay a premium for garbage disposal.

Waste Connection Strategy
Target Secondary and Rural Markets
By targeting secondary and rural markets, WCN is able to achieve a higher local market share than would be attainable in more competitive urban markets. This reduces exposure to customer churn and improves profitability. In certain niche markets, like E&P waste treatment and disposal, early mover advantage improves market positioning and financial returns given a lack of waste disposal alternatives. Secondary markets also help WCN avoid intense price competition which is prevalent in highly competitive markets.  They are shielded from irrational behavior by peers.

Optimize Asset Positioning
The location of disposal sites is critical to profitability given the impact of costs associated with the transportation of waste to treatment and disposal sites.  WCN gains a competitive advantage by focusing on having disposal capacity close to the waste stream.  This proximity provides an additional barrier to entry and a moat for pricing and customer retention.

Control the Waste Stream
WCN attempts to control the waste stream in markets where waste collection services are provided under exclusive arrangements, which creates an environment that is often more profitable than owning or operating the landfill.  In markets with regulations that limit storage and treatment of waste in the area, WCN can generate additional value and revenue from the transportation, treatment and disposal of waste.

Vertically Integrate Services
In markets where WCN believes that owning landfills is a strategic advantage to a collection operation because of competitive and regulatory factors, the company focuses on providing integrated services: collection through disposal of solid waste in company owned landfills.

Decentralize Management
WCN manages operations on a decentralized basis and has built a culture that empowers local managers.  Decentralization provides a more efficient operational structure that places decision making authority closer to the end customer.  This allows WCN to identify and address customers’ needs quickly and cost effectively. Managers have the discretion to execute decisions with senior national leadership acting as a resource and support system.  This combination of decentralization and management-empowered culture is a differentiator and a competitive advantage. The strategy allows WCN to manage the complexities of running hundreds of what are really local businesses at the national level. These same challenges led to the downfall of WCN’s predecessor, Browning-Ferris. WCN’s culture also makes them an attractive buyer for many potential acquisition candidates.  Sellers know that when their company is sold, it will continue to operate with the same culture it had in the past and take care of remaining employees.  Reputation matters, and WCN leverages this reputation in a manner akin to Berkshire Hathaway.

M&A Strategy
Within the industry, WCN is the best positioned to drive consolidation due to their niche focus and market reputation.  More than 50 waste companies in North America generate over $100M in revenue and there are still thousands of “mom and pop” businesses operating in niche markets.  WCN continued their string of successful M&A transactions in 2016 by completing a “merger” with Progressive Waste Solutions to form a company with more than $4B in annual revenue. Management has extensive experience in operating, acquiring, and integrating non-hazardous waste services businesses and intends to continue to focus their activity on niche businesses which meet their stringent acquisition criteria. Once an acquisition is closed, WCN integrates it while minimizing disruption to the ongoing operations and the acquired employees.  In new markets, the company uses an initial acquisition as an operating base to strengthen the operation’s presence in that market through additional services, introduction of new customers, and additional “tuck-in” acquisitions of waste companies in their market or in adjacent markets.

Competition
The North American municipal solid waste industry is highly competitive.  There are three national, publicly traded solid waste companies: Waste Management, Republic Services, and Advanced Disposal Services.  Additionally, there are several regional companies (both public and private), as well as several thousand small, local, privately owned companies.  These companies compete for collection, transfer and disposal volume based primarily on price and quality of services.  Larger customers also have the option of using internal disposal methods.

Management
WCN is led by an industry veteran, Ronald Mittelstaedt, who was part of the management team that acquired the business from Browning-Ferris, and he has been CEO since the company was formed.  The management team is adept at capital allocation and disciplined in their growth through acquisition strategy.  They understand that value is created through FCF generation and that not all markets are created equal.  Mittelstaedt recently took a temporary leave of absence to address health matters affecting him and his family.

Financial Performance and Valuation
Waste Connections trades at a slight premium to peers, as it should. The company has outperformed its larger peers Republic Services and Waste Management, and has delivered 14 consecutive years of positive shareholder returns.

For 2019, management sees 8%-10% revenue growth driven by a combination of organic growth and M&A. Management views the current environment as ripe for consolidation and many of Progressive’s existing contracts are coming up for renewal. The company consistently generates cash flow of 120% to 130% of earnings. WCN has a solid balance sheet with $320M in cash and a reasonable 2.75x Debt/EBITDA ratio.

We valued the company using a DCF model based on growth and profitability assumptions largely in line with industry analyst estimates and which do not account for either significant M&A or price increases to reach a valuation of $107. This is roughly a 30% premium to our purchase price of ~$83/share.

WCN valuation2 

WCN Financials

Conclusion
While a 30% near term (1-year) target is not earth shattering, WCN is a consistent FCF compounder. We are interested in owning franchise businesses with compelling execution strategies and large moats for long term holdings.  These positions balance out our portfolios which often include higher-growth, more volatile names. Management has positioned WCN through market selection to hold pricing power and shelter from irrational competitors’ pricing behavior. Culture matters, and WCN has created a culture that empowers management at the local level and is attractive to smaller waste management companies looking to merge their operations with a national entity.  WCN’s strategy is resilient in a weak economy and levered to an improving economy: defensive characteristics that are attractive at the tail end of a long running bull market where most risky assets are priced to perfection.

Risks

  • The industry continues to face headwinds from declining commodity prices which affects recycling profitability.

  • Recent announcement of CEO health sabbatical clouds picture for near-term M&A activity.
  • M&A environment may become more competitive with other publicly owned regional and national waste management companies pushing prices to levels that are uncompetitive.
  • Increased consolidation in the solid waste services industry will continue to reduce the number of attractive acquisition candidates.
  • Environmental regulations may become more restrictive.
  • While the pay for drivers is capped, WCN is currently facing a shortage of commercial drivers.

[1] RBC Capital Markets estimates.

[2] Browning-Ferris Industries was a North American waste management company and competitor in the waste management industry. BFI collapsed in 1999 under the weight and complexities of running local businesses from a national platform.

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