Route Efficiencies and Landfills Help Waste Connections Dig a Wide Moat

After reviewing

Regulatory permits create enormous structural barriers to entry for the firm's disposal operations, thus producing a strong intangible asset. Developing and operating a landfill requires a host of permits and federal and local government approvals (zoning, environmental protection) that are costly and challenging to secure. On top of that, "not in my backyard" opposition often generates formidable roadblocks to constructing new landfills as well. Waste Connections has also built meaningful cost advantages stemming from superior local route density relative to small waste haulers, most of which aren't vertically integrated. Scale matters in route-based businesses because it bestows greater utilization and leverage over a vast fixed-cost base.

We are also raising our fair value estimate to $59 from $57 because of the moat rating change, partly offset by recalibrating our midcycle operating margin forecast down slightly. That said, the shares are trading in modestly overvalued territory--a common theme among the waste firms we cover. Recycled commodity prices are depressed, but the industry leaders are seeing healthy growth within their traditional solid waste operations thanks to U.S. macroeconomic tailwinds, and this dynamic hasn't escaped investors.

Behind our $59 fair value estimate, we assume that Waste Connections can generate average organic top-line expansion near 4% over our five-year forecast horizon, with another 200- to 250-basis-point boost from tuck-in acquisitions (we look for roughly 350 basis points of deal-related growth in 2018). This reflects average organic traditional solid waste pricing gains near 2.5% (excluding fuel) and volume growth of 1.0%-1.5%. Core solid waste yields will be slightly higher than that this year (3.0%-3.5%) thanks to healthy open-market pricing and because inflation is on the rise (a large portion of the firm's municipal contract pricing is CPI indexed). Waste Connections' core yields have increased slightly less than 3% on average over the business cycle, and waste volume is generally linked to GDP growth, particularly in terms of housing starts. We are assuming recycled commodity prices will stabilize by 2019, though volatility remains a risk that depends in large part on China's appetite for imported old corrugated cardboard and mixed paper in the years ahead. In terms of profitability, we are baking in a midcycle adjusted operating margin near 20.7% (in 2022), which compares with 17.6% in 2017 and our 17.9% forecast for 2018. Our midcycle forecast implies the company successfully takes Progressive Waste's margins up to Waste Connections' historical level--Waste Connections posted a 21% average adjusted margin between 2010 and 2015. It also assumes management avoids overly complicated transactions in the years ahead, and the firm secures favorable economics in its recycling business.

A Deeper Dive Into Waste Connections' Landfills As a fully integrated waste hauler, Waste Connections leverages a vast network of collection routes that bestows control over the waste stream, funneling trash from commercial, industrial, and residential end markets into its valuable landfill assets. In our view, intangible assets (immense regulatory hurdles discourage new landfill ownership) and substantial route density have enabled the company to carve out a robust competitive position that translates into impressive margins and solid free cash flow generation.

In June 2016, Waste Connections (the third-largest integrated waste hauler at the time) merged with the fourth-largest provider, Progressive Waste, roughly doubling in size. The transaction afforded Waste Connections the opportunity to apply its top-tier operational know-how and pricing discipline to bring Progressive's profitability up to par with its own. Waste Connections also gained entrance into new geographic regions, most of which fit its differentiated focus on less-competitive secondary markets--a strategy that's contributed to its industry-leading margins. The firm's progress optimizing Progressive's operations has proved impressive over the past two years, and its overall portfolio is seeing tailwinds from healthy U.S. macroeconomic growth, including strong housing activity. We expect Waste Connections to continue its tuck-in acquisition strategy, and its ability to raise core price on acquired volume (thanks to its vast ownership of landfills, a preferred asset) should support free cash flow growth. Of note, while making up only about 2%-3% of total revenue, Waste Connections' recycling operations are grappling with painful near-term headwinds--prices for recycled commodities the firm extracts and sells, particularly old corrugated cardboard, have plummeted on China's decision to suspend certain import licenses during the second half of 2017. That said, we expect these headwinds to stabilize somewhat as the firm manages facility operating costs and finds other outlets for its recycled commodities, and as China likely eases some import restrictions in the year ahead.

In terms of intangible assets, regulatory permits create immense structural barriers to entry for the firm's disposal operations. Developing and operating a landfill requires facility permits, various licenses, and a host of federal and local government approvals associated with zoning and environmental protection, and such approvals are costly and a challenge to secure. On top of that, "not in my backyard" opposition is no small barrier to constructing a new landfill. Waste Connections also benefits materially from cost advantages linked to superior local route density relative to small regional waste haulers that tend not to be vertically integrated in terms of landfill ownership. Waste Connections is the third-largest integrated provider by revenue (following Republic) in the approximate $60 billion nonhazardous solid waste services industry, with roughly an 8% market share. Outside of exclusive franchise markets (42% of revenue), where it handles all the waste in the given geographic area, the company typically holds the largest or second-largest market position in its "secondary markets" (rural and small suburban markets), which make up 48% of sales. We estimate that Waste Management's market share is around 20% and Republic's is near 15%. Although the top four players enjoy a 45%-50% total market share combined, the landscape is otherwise fragmented, with hundreds of participants, including private operations and municipal and other local government authorities. Size drops off quickly after the three or four largest providers--Waste Management operates 249 landfill sites; Republic has 195; Waste Connections has 90; and Advanced Disposal has 40. In terms of route density, local scale matters in route-based businesses (in this case, collection through disposal) because it provides greater utilization and leverage over a vast cost base (costs linked to landfills, collection equipment, transfer facilities, and so on) relative to smaller providers. Consider that landfills must adhere to strict federal, state, and local environmental regulations that dictate design, construction, operation, monitoring and closure. Landfill operators must also possess the resources to deal with NIMBY opposition, which can be costly and politically charged. Thus, regulation effectively supports high fixed costs, drives the need for significant capital expenditures on environmental protection, and creates material financial liabilities for final capping and closure of landfills. When combined with financial and legal resources and deep local market route density, landfill ownership (enjoyed by vertically integrated providers) translates into a formidable advantage that keeps smaller competitors at bay thanks to lofty fixed costs and regulatory hurdles. Industry players that control the greatest amount of landfill assets in a region ultimately command pricing power on both integrated business (collection and disposal) and landfill business (tipping fees charged to third-party haulers). Waste Connections' traditional solid-waste pricing gains (excluding fuel) averaged slightly more than 3% over the past economic cycle (2008-17). It's worth noting that Waste Connections has managed to differentiate itself slightly from its two larger peers because of a long-standing focus on "franchise" markets (defined by very long-term exclusive contracts that are rarely rebid) and "secondary" markets (nonfranchise rural and small suburban markets) rather than more competitive urban markets. In secondary markets, Waste Connections often has the only landfill in the vicinity or is maybe one of two. Thus, even if it loses collection business in those markets, that same waste could end up at its landfills anyway via third-party haulers. There's also far fewer collection companies to contend with in secondary markets. In more populous urban markets, hosts of small waste haulers can drag collection pricing down while also pitting landfills against one another, especially during downturns. In terms of mix, 42% of Waste Connections' top line derives from franchise markets, 48% from secondary markets, and 10% from urban markets. For Republic, that mix is around 29%, 34%, and 37%, respectively.