Waste Connections: Growth By Acquisition Strategy Under Pressure

[Please note that all currency references are to U.S. dollar except if indicated otherwise.]

Waste Connections (NYSE:WCN) $132.19 (New York and Toronto symbol WCN) provides residential and commercial waste management services in the U.S. and Canada. The company was founded in 1997 and listed on the New York exchange one year later. The headquarters is in Montreal, Canada.

Waste Connections has developed an impressive track record of profitable growth. This was achieved by growing organically and supplemented by regular acquisitions of mainly smaller waste management operations.

The stock is valued for a continuation of its high growth history, which seems unlikely to persist beyond 2023.

An important waste management operator

Waste Connections is the third largest North American provider of non-hazardous, solid waste collection and disposal services. Services are provided to over eight million residential, commercial, and industrial clients located in 43 U.S. states and six Canadian provinces.

Revenues are generated from charging fees to customers for the collection, transfer, recycling, and disposal of waste. Additional income is received from the recovery and sale of cardboard, plastic, and metals, the delivery of oilfield waste treatment services, as well as the movement of solid waste containers. The company’s main focus is on less competitive secondary and rural markets rather than the dense and highly competitive urban markets.

In 2021, 72% of revenue was derived from solid waste collection, 20% from waste disposal and transfer, and the balance from recycling and other operations. In the same period, 86% of revenue was from the U.S. with the rest from Canada. Waste Connections owns and operates 97 landfills for waste disposal, which provides an important competitive edge.

Estimates indicate that the number of landfills in the U.S. declined drastically over the past four decades to around 1,500 as costly environmental requirements pushed many small landfill owners out of business. Public companies such as Waste Connections, Waste Management (260 landfills), and Republic Services (198) now own a substantial portion of these valuable assets.

The company generated revenues of $6.9 billion over the past 12 months and a net profit of $808 million. The staff count is around 20,000, of which about half are truck drivers and another 1,500 mechanics. About 15% of the workforce is employed under collective bargaining agreements.

A sound long-term track record

Waste Connections has a solid track record of growing its revenues and profits over time, organically but also through multiple acquisitions. Over the past 10 years to the end of September 2022, gross profit increased by 14% per year, net profit by 24% per year, earnings per share by 11%, and free cash flow per share by 16%. Growth has also been consistent except for the drop in profits and cash flow in 2020 during the peak of the initial Covid period.

Profit margins have consistently been high over the past decade (except in 2020) with gross and EBITDA margins averaging 39.8% and 28.5% respectively. The pre-tax return on assets averaged a poor 4.7% over the 10 years but has been depressed by large goodwill and intangibles additions that came about with the 2016 merger with Progressive Waste (see below).

Waste Connections compares well with its main peers, Waste Management and Republic Services. Profit margins have been on par although the return on assets has been lower. Profit growth was higher, and the stock returns were a little better than the peers.

Growth prospects – acquisitions required

Waste Connections has a three-pronged growth strategy. First, to increase its roster of exclusive agreements with municipalities or other contractual counterparties to be the sole provider of services for a specific area. This allows the company to “control the waste stream” and improve its profitability by optimizing the services on offer.

The company claims to have 40% of its current mix linked to exclusive contracts. Second, the company targets internal growth by increasing its volume throughput by offering additional services, price increases, and improvements in operating efficiencies. We estimate that about half of the company’s revenue growth over the past 5 years came from price increases and volume throughput growth.

Third, the acquisition of (mostly) smaller waste businesses in existing or new markets. Over the past 5 years, the company spent over $5 billion acquiring on average more than 20 companies per year. These acquisitions added 5% per year to revenues and probably slightly more to EBITDA. The company’s most significant corporate transaction took place in 2016 with the merger with Progressive Waste.

This doubled the size of the business in the process. The playbook to extract value from the merger included the shedding of marginal or unprofitable contracts, the improvement of operational performance, and the safety record.

At the time of acquisition, Waste Connections stated that the EBITDA of the acquired business could increase by 25% or more and free cash flow by 100% within 3 years.

In early 2017 the company’s management commented that the integration and objectives were running well ahead of the targets. Given the strong expansion in the EBITDA margin (5 percentage points between 2015 and 2018), the merger could be considered a success.

Risks – mainly environmental

The company’s operations are subject to an extensive range of government laws and regulations related to solid waste operations. which may render the company liable for claims. In addition, the company is also liable for the remediation of landfills when they reach the end of their useful life.

Corporate governance: Founder at the helm

The executive chair of the board is Ron Mittelstaedt (age 59). He founded the business in 1997 with the acquisition of a few solid waste companies in the Northwest United States. He holds a degree in business economics from the University of California at Santa Barbara.

Worthing Jackman (age 58) is the Chief Executive Officer; he was appointed to this role in July 2019. He was previously the Chief Financial Officer (since 2004) after joining the company in 2003. He holds an MBA degree from Harvard Business School.

The board of directors consists of eight members, of which six are considered independent. The average age of board members is 66 years. The directors and executive officers jointly owned less than 1% of the outstanding common shares as of March 2022. The largest shareholders in February 2022 were The Vanguard Group and T. Rowe Price, which both held 10% of the outstanding common shares. Key aspects of executive compensation are a base salary, an annual cash performance bonus scheme, and an equity-based long-term incentive plan.

The 2021 bonus scheme was based on EBITDA and operating income targets (40% weight), and EBIT and the operating cash flow margins (60% weight). Long-term incentives are based on improvement in the return on invested capital and the growth in free cash flow.

The CEO received total compensation of $5.0 million and $7.3 million for the 2020 and 2021 fiscal years, respectively. The executive chair earned a total compensation of $1.6 million in 2021.

Growing debt and financing costs will curtail future growth

The company had shareholders’ equity of $6.9 billion at the end of September 2022 while total debt amounted to $6.2 billion; the debt-to-capital ratio was 47%.

Total debt has grown by 53% over the past 3 years while the financing costs ballooned to an expected $200 million for the 2022 fiscal year. The total debt/EBITDA ratio is 2.8 times while EBITDA covers the finance cost a healthy 12.4 times.

Management targets a debt/EBITDA ratio of 2.5 times-3.0 times. The main rating agencies ascribe investment-grade credit ratings to the company.

Cash flow from operations amounted to $1.9 billion over the past 12 months while capital expenditures were $0.9 billion, leaving a sound free cash flow balance of $1.0 billion. Free cash flow is stable and remained consistently positive over the past 5 years.

An important part of the company’s growth strategy is regular acquisitions as described above. With the debt level now close to management’s target debt ceiling, we estimate that share buybacks and/or acquisitions will have to be scaled back over the next two years. This will dampen the revenue growth rate and all measures of profit growth at the per-share level.

Impressive dividend track record

Waste Management pays a quarterly dividend which amounted to $0.945 per share over the past 12 months. Adjusted for stock splits, the dividend has grown by 14.4% per year.

There has been no omission or drop in the dividend in any year for the past decade. The company also, from time, buys its shares in the market. However, the count of outstanding shares has only declined marginally over the past 5 years. The company received regulatory approval to purchase for cancellation over the 12 months starting August 2022, 12.9 million shares (around 5.0% of its ordinary shares and a $2.3 billion cost at the current share price).

We note that the company used only 22% of the previous year’s regulatory approval for share buybacks and consider it highly unlikely that the current program will be fully utilized.

Recent results: Solid operational performance but finance costs up sharply In the most recent quarterly results for the period to the end of September 2022 (nine months of the company’s 2022 fiscal year), revenues increased by 18.0%, operating income by 17.7% while adjusted diluted earnings per share increased by 22.6%.

The CEO was upbeat at the time of the results announcement, with an upgrade to previous full-year growth expectations. He also highlighted an expected double-digit growth in revenues, margin expansion, and contributions from new acquisitions to support growth in 2023.

Consensus estimates indicate earnings per share of $3.80 (mean) for the year ending December 2022, which will be 17.6% higher than the previous year. These forecasts also indicate a 12.5% growth in earnings per share for each of the following two years.

This sounds plausible given the track record of the company, but we are skeptical that the growth by acquisition strategy can continue given the already high debt levels of the company.

Reasonable valuation – only if high growth continues

The current valuation of Waste Connections based on the results for the past 12 months is very close to the 5-year average. Given consensus forecasts for the next 12 months, the business is valued on an EV/EBITDA ratio of 15.5 times, and a price-to-cash flow ratio of 14.9 times.

Compared to the peer group indicated in the table, Waste Connections trades at an EV/EBITDA premium to its peers. The company has been growing faster than its peers, which probably supports the premium valuation. However, if growth expectations are scaled back, the premium valuation may well move to a discount.

Quality business but valuation will adjust as growth expectations are scaled back

Waste Connections has built an enviable track record of profitable growth over the past two decades. Regular, smaller acquisitions supported the growth momentum but also pushed up the level of debt.

Without acquisitions, the growth rate will likely fall back to mid-single digits, which in turn will depress the valuation multiple and shareholder returns.

By Deon Vernooy, CFA, for TSI Wealth Network