Three Stocks That Turn Garbage into Cash

Some of the companies most admired by Morningstar stock analysts aren't flashy tech names or hot commodity companies. Rather, they are the companies that provide essential services for everyday life. Although the waste management industry is by no means glamorous, it comprises companies with business models that are profitable during good times and bad--and that generate ample cash. Despite these companies' historical resistance to economic cycles, the broad market sell-off has caused some of the highest-quality stocks in the industry to trade at a discount to our fair value estimates.

Moaty and Profitable in Tough Economic Times
The waste market is a $52 billion market, and the "Big Three" ( Waste Management ,  Allied Waste , and  Republic Services (RSG)) have a combined market share of roughly 45%. Waste haulers generate the majority of their revenues from two main services--waste collection and waste disposal. The waste collection business is a commodity service that isn't moat-worthy, in our view. Basically anyone who can purchase or finance a dump truck can bid on collection services and enter the industry. Also, switching costs for cities and residents are relatively low, and there is virtually no brand loyalty. Therefore, the source of many of our waste haulers' narrow moats lies in the disposal business. The most successful firms in the industry typically exhibit one competitive advantage: ownership of landfill airspace. Obtaining landfill airspace is no small feat. Landfill permits and approvals can take anywhere from three to seven years to obtain and are typically fraught with NIMBY ("not in my back yard") opposition from citizen groups. Waste collectors that also own the landfill airspace near a route can charge higher tipping fees to collectors who don't own landfills, giving the landfill operators a distinct low-cost advantage. The Big Three waste haulers are also the largest domestic landfill owners, and accordingly generate operating margins 400 to 600 basis points higher than the industry average of 11%. The landfill business usually represents around 30% of these firms' revenue, but close to 50% of operating profit, due to the higher-margin nature of this business.

Many investors fear that an economic slowdown in residential or industrial construction is detrimental to waste haulers' revenue growth and profitability. While slowing residential and industrial construction typically leads to lower waste volumes, this cyclical waste activity only minimally affects waste haulers' revenue growth. Let's walk through an example. In 2007, Waste Management earned 56% of its revenue from its collection business. Of this 56%, roughly 29% is directly related to roll-off activity (picture the large, rectangular waste containers normally seen at construction sites and factories). Approximately 50% of roll-off activity is temporary in nature (related to a roughly equal mix of residential and nonresidential construction) while the other 50% is permanent (typically related to manufacturing facilities). Based on these numbers, we estimate that a worst-case scenario--where both new residential and commercial construction activity stops completely--would yield only an 8% decline in Waste Management's revenue.

Changing Industry Dynamics of Waste Disposal
Prior to 2005, the waste industry focused extensively on improving route density by competing on price in regional markets. This price war, coupled with rushed acquisitions, hurt the profitability of many companies in the industry. For example, companies such as Allied Waste and Waste Management levered up their balance sheets to fund acquisitions that never lived up to managements' promises for synergies and other benefits. However, in more recent years, most management teams seem to have improved profitability through more rational pricing and a disciplined approach to growth. The industry has successfully raised core pricing on disposal services in a range of 3% to 6% annually over the past three years, and we expect this pricing trend to continue. The industry's favorable pricing couldn't come at a better time; industry participants have been able to maintain or even increase operating margins, despite higher fuel prices and lower waste volumes stemming from a slowdown in industrial and residential construction.

Although waste haulers can't raise prices forever, we think industry consolidation can help prolong the good times. In June, the third-largest waste hauler, Republic Services, announced it would acquire the second-largest trash taker, Allied Waste, in a friendly merger of equals. The deal would give the combined entity roughly 18% of the market, closing the gap on Waste Management's dominant 23% market share. In an effort to block the merger, Waste Management attempted to acquire Republic and even subsequently raised its original offer. However, with credit markets gridlocked and a possible large debt load ensuing from the deal, Waste Management pulled its bid, paving the way for a Republic-Allied merger. Post-merger, roughly 70% of all disposal capacity and 40% of all landfills will now be in the hands of two major players, setting the stage for years of more rational competition. Accordingly, we're forecasting industry price increases of 4% annually over the next five years.

So you might ask yourself how this round of consolidation is different from the botched attempts in the 1990s. First, the Allied-Republic merger is an all-stock transaction, eliminating the excessive leverage that was employed in past mergers. Second, this round of consolidation is more than just a roll-up of companies in an effort to grab market share. Companies now operate in similar business lines (collection, disposal, transfer, and recycling) and are focused on common performance metrics, such as returns on invested capital and free cash flow. Because firms are focused on increasing returns on capital, they are willing to divest of duplicate assets and waste routes.

We think industry consolidation this time around is a good thing, and that it will set the stage for years of rational price increases.

Our Recommendations
Although we think the waste management industry will continue to exhibit strong fundamentals going forward, we would caution investors to steer clear of highly levered companies such as  Casella Waste (CWST) or  Waste Services  that don't exhibit the regional route density and cash-flow-generating ability of other larger players. Our recommendations in the space are:

 Allied Waste 
Uncertainty Rating: High | Economic Moat: Narrow | Four Stars
The industry's second-largest waste hauler will be acquired by the number-three waste hauler, Republic Services, by year end. The merger will create a combined entity with 219 landfills, $9.3 billion in annual revenue, a combined market share of 18%, and annual synergies of $150 million a year. Allied will inherent Republic's exclusive regional contracts for waste disposal in areas like Las Vegas, Los Angeles, and parts of Florida and Texas, which represent roughly 40% of Republic's revenue. These long-term contracts typically span close to 30 years and provide a fairly predictable stream of revenue. With long-term contracts and landfill locations across the nation, we think it would be extremely difficult for smaller competitors to compete with the combined Republic-Allied entity.

 Waste Management 
Uncertainty Rating: High | Economic Moat: Narrow | Four Stars
Waste Management is the nation's largest waste hauler with more than 217 landfills. The company has steadily increased prices over the past three years by raising core disposal prices by 3%, which has helped expand operating margins from 13% to 17%. In addition, the company has implemented a "fix-it-or-seek-exit" asset optimization strategy, which disposes of lower-margin businesses and unprofitable waste contracts. Although waste volume may be reduced because of this initiative, the firm can divest unprofitable assets and steadily increase its returns on capital for years to come.

 Republic Services (RSG)
Uncertainty Rating: High | Economic Moat: Narrow | Four Stars
Currently Republic is the third-largest domestic waste hauler in terms of landfill capacity, with 58 landfills. The Allied merger will increase landfill ownership to 219 landfills, making Republic the second-largest domestic waste hauler while increasing its regional route density. In addition, approximately 54% of its revenue comes from the expanding Sunbelt regions of the country. Access to states such as California, Texas, and Florida gives it exposure to regions that have exhibited strong population growth and offer potentially higher waste volumes, in our opinion. Further, Republic operates exclusive regional contracts (essentially monopolies granted by the government) for waste disposal in areas like Las Vegas, Los Angeles, and parts of Florida and Texas. Roughly 40% of Republic's revenue is generated from these long-term contracts that span close to 30 years in duration. With long-term contracts and landfill locations across the nation, we think it would be extremely difficult to compete with Republic.