The Case for Waste: Finding Growth in Garbage
Published on December 7, 2020
Although investors don’t normally think about trash when they’re looking for growth stocks, we believe the solid waste industry is well-positioned to outperform. In our view, the combination of high barriers to entry, stable demand, and opportunities for consolidation should provide reliable revenue growth for the foreseeable future.
The waste industry has changed significantly over the past several decades. Still in the minds of many investors are the scandals dogging the industry through the late 1990s and early 2000s, not to mention whispers about past connections to organized crime. But the companies operating in today’s waste industry have evolved into highly predictable financial compounders based on vertical integration. The industry is now dominated by three large players protected by significant regulatory barriers that make it nearly impossible for new competitors to enter the market, which provides the incumbents with both pricing power and years of runway for consolidation.
Solid Waste Industry: A Troubled Past
The modern waste industry started with the IPO of Waste Management, Inc. in 1971. Beginning in the mid-1970s, Waste Management launched a multi-year consolidation spree, leading other players to follow suit. The industry rapidly consolidated for the next 20 years. Not surprisingly, poor capital allocation decisions were made along the way, including entering unrelated business lines and far flung waste markets with poor regulatory frameworks.
By 1998, the party ended with a thud as Waste Management admitted to massive accounting fraud and made what was then the largest financial restatement in corporate history. The legal issues related to this fraud dragged out until 2005. As investor scrutiny increased, the waste companies began scaling back unrelated and international operations to focus on the core North American waste industry.
As often happens following a major industry scandal, the waste companies went from Wall Street darlings to corporate duds by the early 2000s. Adding to this industry upheaval have been persistent concerns about limited landfill capacity.
But the Future Looks Promising
Despite the industry’s rough history, we believe the future is quite bright for the North American waste service providers. Their underlying business model is highly attractive, characterized by stable demand, meaningful pricing power, and low-risk consolidation opportunities.
The North American solid waste industry generates roughly $80 billion of annual revenue. This revenue is comprised of multiple business lines: over 60% of revenue is generated by collection of solid waste and recyclable and compostable items; 25% of revenue is generated by disposal; the balance is generated by transfer and processing. The large public players are all vertically integrated and therefore own and operate truck fleets for collection and transfer, in addition to recycling, composting, and landfill facilities for sorting and disposal.
The industry grows roughly in line with GDP, driven by flat to very modest volume growth and bolstered by pricing that can significantly exceed inflation. Given the non-cyclical demand for waste disposal and recycling, industry revenue tends to be stable and slightly lags the broader economic cycle. For example, U.S. solid waste industry revenues grew 3% in 2008 and declined by only 4% in 2009.
The waste industry has further consolidated over the past 20 years. Today, almost 60% of North American revenue sits in the hands of the publicly traded companies, while private companies account for roughly 25% of the market, and local municipalities account for the balance of industry revenue.
Local Market Dynamics Are Key to Pricing Power
While macro level statistics are important to understand and reflect bigger picture trends, local dynamics are critical to each market’s economics. Some markets are highly competitive and therefore less attractive. Others are effectively regulated monopoly markets with long-term exclusive contracts granted to the waste provider by local municipalities that allow for annual pricing escalators. Still other markets are not exclusive but have only one player, enabling even greater pricing power for that lone operator. The local competitive dynamic is therefore a key determinant of long-term pricing power and returns on capital.
In addition, local landfill capacity is critically important to pricing. Given that most solid waste ends up in a landfill, companies that own these assets have a key strategic advantage in setting pricing. Importantly, landfill capacity in North America is highly regulated and constrained. From 1990 to 2017, the number of U.S. landfills decreased by roughly 80%, and today nearly 2/3 of U.S. landfills are owned by the three largest industry players. While building new landfills is extremely difficult, landfill capacity at existing sites can be gradually expanded, as long as the incumbent has been a reliable and safe operator. As a result, today’s landfill owners have significant pricing power and a path to gradually expanding capacity.
Importantly, the waste stream has become much more environmentally friendly over time. Landfills today have sophisticated physical infrastructure and effective monitoring in place to reduce and manage pollution. Moreover, as of 2018, 38% of municipal solid waste was being recycled or composted, and 12% was being converted into energy. Lastly, operators are shifting to lower emission trucks powered by compressed natural gas, with the longer-term goal of operating zero emission all-electric trucks. These trends are increasing over time, creating a more sustainable and environmentally friendly waste stream and reducing carbon emissions.
Case Study: Waste Connections, Inc. (WCN)
While the waste industry in aggregate is attractive, we have chosen to invest in what we consider the company with both the highest quality asset base and the best management team: Waste Connections, Inc., the third largest solid waste services provider in North America.
Waste Connections is vertically integrated. It provides residential, commercial, and industrial solid waste collection through its truck fleet and offers disposal through its network of nearly 100 landfills, more than 65 recycling facilities, and over 120 transfer stations.
The company has a unique strategy within the industry, distinguished by the quality of its local markets, its landfill ownership, and its steady execution of acquisitions. Since its founding, Waste Connections has always been vertically integrated and has targeted rural and secondary markets. As discussed above, local competitive dynamics and landfill ownership underpin pricing power. As a result of the company’s highly focused strategy, Waste Connections enjoys by far the highest pricing power in the industry, which enables attractive and predictable revenue growth.
High return acquisitions have also been core to the Waste Connections strategy. The company has steadily acquired operations in less competitive markets, leading to consistent inorganic growth. Importantly, much of the acquisition-led growth has been funded with internally generated cash flow, avoiding high financial leverage that could create unnecessary risk.
As a result of WCN’s focus on pricing power, the business consistently generates organic revenue growth and operating margins above its peers. The company also regularly delivers high single digit growth in free cash flow (FCF), which is particularly compelling given the stability of the business. For example, despite the current deep recession, Waste Connections has managed to grow free cash flow (through the first nine months of 2020 vs. the same period in 2019). This financial performance is a testament to the quality of Waste Connections both in terms of asset base and management team.
Beyond 2020, margins and FCF conversion could come in stronger than expectations as the company integrates a high level of acquisitions completed in the past several years.
Looking Ahead
We believe the solid waste sector will remain attractive for the foreseeable future, and we are particularly bullish on WCN. At the industry level, demand is stable, organic growth is consistent, and substantial regulatory barriers should continue to protect the large incumbents and ensure continued price-led growth. We anticipate Waste Connections will benefit from these trends as it continues to expand through acquisition. Roughly 40% of the North American solid waste industry is still in the hands of private operators and municipalities, creating substantial opportunity for steady “tuck-in” acquisitions well into the future.
Nael Fakhry
Co-Chief Investment Officer – Core Equity
Featuring
Nael Fakhry
Co-Chief Investment Officer – Core Equity
Prior to joining Osterweis Capital Management in 2011, Nael Fakhry worked as an Associate at American Securities, a private equity firm, and as an Analyst in the investment banking division of Morgan Stanley.
He is a principal of the firm and Co-Lead Portfolio Manager for the core equity, growth & income, quality cyclical growth, and flexible balanced strategies.
Mr. Fakhry graduated from Stanford University (B.A. in History, Phi Beta Kappa) and the University of California Berkeley, Walter A. Haas School of Business (M.B.A., C.J. White Scholar).
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