Waste Connections Inc. Stock Analysis – Too Expensive For Me (Part 1 Of 3)

Summary

  • This Waste Connections Inc. stock analysis is the 1st of a 3 part series on the largest non-hazardous solid waste collection companies.
  • The non-hazardous solid waste collection industry is highly fragmented due to its low entry barriers.
  • Growing to a meaningful size is not easy and requires readily accessible sources of capital.
  • Growth by acquisition presents challenges as WCN has learned after closing the Progressive acquisition.
  • WCN’s management has indicated that above average acquisition activity could utilize existing/projected excess cash flow over the next few quarters.
  • In my opinion WCN is expensive at current levels.

Introduction

Several years ago I came to the realization that a top-down approach to investing was more suited to my personality. I am not saying that a bottom-up approach is an inferior approach but I just never felt it made any sense for me to pore over the fundamentals of multiple individual stocks if the industry ultimately had little appeal to me.

Using this top down approach, I have identified investment opportunities just by going about my daily life.  This brings us to this series of posts about the three largest non-hazardous solid waste collection, transfer, disposal, recycling and energy services companies in North America.

  • Waste Connections Inc. (NYSE: WCN) – market cap ~$17.03B
  • Republic Services, Inc. (NYSE: RSG) – market cap ~$21.85B
  • Waste Management, Inc. (NYSE: WM) – market cap ~$33.53B

The purpose of this 3 part series is to determine which, if any, of these companies would be a worthwhile addition to, or outside, the FFJ Portfolio. I will commence with the smallest of the 3 companies and will end with the largest. I will also only include a review of the industry in this initial post.

Industry Review

The non-hazardous solid waste collection, transfer, disposal, recycling and energy services industry is highly fragmented. Participants range from operators with one vehicle to large publicly traded multi-national companies.

In some regional areas there are thousands of private small to midsized operators which compete aggressively on price. These small private operations account for approximately 30% of the market. In addition, approximately 25% consists of municipalities that manage their own waste removal/processing.

The collection, transfer, and disposal of waste generated by households and businesses are how domestic waste managers generate the bulk of their revenue. They also earn additional income through the selling of recycled waste products or through recycling fees.

Revenue for the industry has grown steadily over the past 5 years. The industry has benefited from population growth, rising industrial, construction and commercial business activity which has led to greater waste production, thus generating demand for industry services. In addition, growing interest in solid waste recycling and renewable energy generation from solid waste has created opportunities for the industry to generate additional revenue.

Larger operators have the following advantages:

  • Municipalities are expected to continue privatizing waste collection and disposal services and smaller operators are generally unable to meet many municipalities’ stringent requirements;
  • Economies of scale;
  • Broader range of services;
  • Larger operators have an easier ability to access capital for further investment and acquisitions, and therefore, there is a trend of consolidation and integration which will continue to slowly reduce competition in the industry.

Major barriers to entry include:

  • Vertical integration – large operators have the means of disposing the waste they collect at landfill sites they own;
  • Effective cost control – fuel costs are a heavy cost component and some operators are trying to convert trucks to run on less expensive fuels;
  • “Tipping Fees” – A firm that does not own or operate landfills must pay such a fee to gain access to one. Tipping fees can be substantial which means firms that control landfills have a significant competitive advantage;
  • Heavy government/environmental regulation – there is a limited supply of landfill space. Any firm wishing to build a new landfill must have sufficient capital to excavate and operate it. Any plans to open a new landfill will also be met with vigorous opposition from most communities and environmental groups. An example of this is WCN’s Chiquita Canyon expansion in LA County. The issue was sufficiently significant for management to indicate on its Q2 2017 conference call held June 26th that:

“Growth will be impacted by the lower annual tonnage limitations imposed under the new 60-million ton 30-year conditional use permit at our Chiquita Canyon Landfill in Southern California beginning August 1.

Regarding Chiquita Canyon, in addition to tonnage limitations, the new permit increases local taxes and fees by about $15 million per year and increases certain cost imposed on the operating conditions. The projected total impact of the permit condition changes is between $15 million and $20 million first-year hit to EBITDA, which we hope to recover some of over time as disposal rates in that market rise.”

In essence, the most successful firms in this industry are fully integrated in that they own their collection services, transport stations, and landfill space.

Energy and Petroleum (E&P) waste can be another significant source of income for the industry. Income is generated from the removal of the waste by-products of oil and natural gas production. This source of revenue was a significant driver of earnings but the downturn in the oil and gas industry in recent years has constrained drilling activity.

Despite a competitive environment, pricing is expected to continue to drive top-line organic growth.

Commodity recycling prices have been a major headwind for the industry. Expectations are that they will stabilize at low levels before slowly moving higher.

The largest North American haulers will continue to divest under-performing assets. In addition, selective and accretive acquisitions are expected to continue and continued focus will be placed on enhancing customer service in order to maintain a high retention rate.

While landfill capacity averages more than 20 years, landfill prices (landfills tend to generate higher margins) should rise over the next few years. This is expected as more third-party waste is disposed of in the largest haulers’ landfills.

Readers interested in learning more about the multiple Risk Factors faced by industry participants (and risks faced specifically by WCN) are strongly encouraged to access the pdf version of WCN’s Form 10-K for the fiscal year ending December 31, 2016. A comprehensive list of the risks commences on page 40 and ends on page 51 (if you decide to download the pdf document)!

Business Review

As at December 31, 2016, WCN’s most recent fiscal year end, WCN served residential, commercial, industrial and E&P customers in 40 states and the District of Columbia in the U.S. and five provinces in Canada. It owned or operated a network of:

  • 261 solid waste collection operations
  • 135 transfer stations
  • 7 intermodal facilities
  • 71 recycling operations
  • 93 active municipal solid waste (MSW) Energy & Petroleum (E&P) and/or non-MSW landfills
  • 22 E&P liquid waste injection wells
  • 17 E&P waste treatment and oil recovery facilities.

In addition, WCN’s non-MSW landfills accept construction and demolition, industrial and other non-decayable waste.

WCN 2017 Footprint
WCN 2017 Footprint

(Source: WCN August 2017 Investor Presentation)

WCN views itself as the premier provider of solid waste collection, transfer, recycling and disposal services in mostly exclusive and secondary markets across the U.S. and Canada. It is a leading provider of non-hazardous E&P, waste treatment, recovery and disposal services in the U.S. through its R360 environmental solutions subsidiary. It also provides intermodal services for the rail haul movement of cargo and solid waste containers in the Pacific Northwest.

I previously noted that the E&P waste business can be a significant source of income but this is not always the case. In fiscal 2015, WCN recorded net impairment charges of approximately$0.497B against its E&P segment as a result of the downturn in the oil and gas sector. This sizable impairment charge resulted in WCN’s 2015 Key Financial Ratios being in marked contrast to its typical annual profitable performance.

WCN Ratios from Morningstar
WCN Ratios from Morningstar

(Source: Morningstar)

As WCN is fully aware, growth by acquisition comes with risks as it never really knows what it is acquiring until it “looks under the hood”.

On June 1, 2016, WCN completed the acquisition of Progressive Waste thus effectively doubling the size of WCN and significantly expanding its geographic footprint. Once the acquisition was completed, WCN realized it had assumed Progressive was a better run company than in actuality. It found health and safety related incidents were 3.5 times that of WCN facilities which led to a 42% to 44% employee turnover. This turnover level is something WCN had experienced at its operations 9 – 10 years ago. Quick action was taken to improve workplace safety and incidents at legacy Progressive operations have dropped almost 50% in just 7 months after closing. In addition, WCN has witnessed a 35% – 40% improvement in turnover.

In addition to improvements on the health and safety front, WCN:

  • has converted Progressive’s operations from a low priced, volume-led growth focus to a price-led, organic growth model;
  • is shedding approximately $50 million of low priced, negative margin or cash flow, or unsafe-to-service revenue;
  • is in the process of divesting markets in the U.S. with over $200 million of revenue that are inconsistent with its differentiated strategy.

Q2 + 1H FY2017 and Guidance for Remainder of FY2017

On July 25, 2017, WCN released its Q2 + 1H FY2017 and Guidance for Remainder of FY2017.

WCN Differentiated Strategy
WCN Differentiated Strategy
WCN - Targeting Attractive Markets
WCN – Targeting Attractive Markets
WCN 1H 2017 Highlights
WCN 1H 2017 Highlights
WCN Outlook for Remainder of FY2017
WCN Outlook for Remainder of FY2017
WCN - Adjusted EBITDA
WCN – Adjusted EBITDA
WCN Adjusted FCF
WCN Adjusted FCF

(Source: WCN August 2017 Investor Presentation)

Long-Term Debt

This is a highly capital intensive industry. Leverage is used to fund fixed assets and mergers and acquisitions.

The following snapshot of WCN’s debt position was taken from page 68 of the pdf version of the 2016 10-K.  There does not appear to be any significant debt coming due in the short-term.

WCN - Debt snapshot
WCN – Debt snapshot

(Source: WCN 2016 10-K)

Dividends, Stock Splits, and/or Share Buybacks

WCN’s stock split and dividend history can be found here. Currently, the dividend yield is sub 1% (share price ~$64.60. If you are a dividend yield hungry investor who relies heavily on stock screeners to identify investment opportunities and one of your metrics is for a dividend yield in excess of 1%, WCN will never show up on your radar screen.

I am currently retired so I like a steady stream of dividend income. I will not, however chase yield as I view this strategy as fraught with risk. Despite my desire to generate an ever increasing stream of dividend income, I am willing to hold shares in low dividend yield companies if:

  • management has a dividend policy which will result in future dividend increases;
  • the dividend payout ratio has room for expansion;
  • FCF and Operating Margins provide ample room for safe dividend increases.

In the case of WCN, the dividend was increased 24% in FY2016 when factoring in the 3 for 2 stock split in June 2017. Management has also indicated there is a strong likelihood of another double digit percentage dividend increase in October 2017.

WCN’s dividend payout ratio is well below that of RSG and WM and its ample FCF would allow it to increase its dividend to a level closer to its peers. Readers should note, however, that management has indicated that above average acquisition activity could utilize existing/projected excess cash flow over the next few quarters. Given this, a significant dividend increase and/or a reduction in share count are highly unlikely.

I suspect management will continue the double digit percentage dividend increases but I am of the opinion investors will need to wait a long time before WCN’s dividend payout ratio approaches that of RSG and WM. I am also of the opinion that if a huge focus is on growing the business, share count is unlikely to experience any significant reduction in the foreseeable future. The following chart reflects the number of outstanding shares for the 2007 – YTD2017 period; the dramatic jump in FY2017 is attributed to the 3 for 2 stock split.

WCN Share Count
WCN Share Count

Valuation

The consensus FY2017 adjusted EPS estimate is $2.13. Using this estimate and the current stock price of $64.60, I get a forward PE ~30. In my opinion, investors are paying up for WCN’s growth story and the amount they are willing to pay is exacerbated by the current euphoric market conditions.

WCN TD WebBroker EPS Estimates
WCN TD WebBroker EPS Estimates

(Source: TD WebBroker)

This forward PE ratio is also somewhat elevated relative to historical levels although I can appreciate that the WCN of today is very different from the WCN of a year ago.

WCN Morningstar PE Ratios
WCN Morningstar PE Ratios

(Source: Morningstar)

Compound Annual Growth Rates

The following compares the Compound Annual Growth Rates for various metrics for all three companies covered in this series of posts; WCN is more of a growth story than RSG and WM.

CAGR for WCN RSG and WM
CAGR for WCN RSG and WM

All 3 companies are somewhat different and each will have a different level of appeal to investors.

WM investors have been benefiting from a gradual reduction in share count and razor thin annual dividend increases and not from any growth.

In fact, in FY2009 revenue declined because of a rapid drop in commodity prices in Q4 2008 resulting from a significant decrease in the domestic and international demand for commodities. A further drop in revenue was evidenced in FY2015 because it sold Wheelabrator.

RSG experienced its dramatic growth in 2008 and 2009; it did its major acquisition in 2008 which vaulted it to the #2 spot in the industry. The fact that acquisitions is being accorded less money than dividend increases and share repurchases in FY2017 is a sign that management feels it can grow the business organically and only the occasional tuck-in acquisition is required.

WCN, on the other hand, is in growth mode. While it is still digesting Progressive, management has indicated that above average acquisition activity could utilize existing/projected excess cash flow over the next few quarters. In my opinion, growth by acquisition presents slightly more risk than organic growth and tuck-in acquisitions so you may want to keep this in mind if you are looking to invest in this space.

Waste Connections Inc. Stock Analysis – Final Thoughts

I find the highly fragmented non-hazardous solid waste collection, transfer, disposal, recycling and energy services industry to be extremely attractive. While the barriers to entry are low, the ability to grow is extremely challenging given the hurdles reflected in the Industry Review section of this post. This presents opportunities for the largest participants in this industry because there is a pool of companies that just do not have the resources to get to the next level.

Having said this, I am of the opinion some companies (WCN is included amongst said companies) are valued at unrealistic levels. I suspect many companies are likely to experience a contraction in their valuation levels if/when investors realize that it takes a long time to generate a decent return on investment when you overpay.

Based on my investor profile and current market conditions, I would look at initiating a position in RSG or WM before initiating a position in WCN.

I encourage you to read my upcoming RSG and WM posts, however, to get my final take as to whether I am prepared to add them to my FFJ Portfolio.

Note: I sincerely appreciate the time you took to read this post. As always, please leave any feedback and questions you may have in the “Contact Me Here” section to the right.

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I currently have no position in WCN and am unlikely to initiate a long position within the next 72 hours.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.

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