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Turbulent times or dollar signs? - An economic view of the US waste industry

By: Terry McWilliams - Date: 10/07/2008

The year of eonomic turbulence’ might well be how 2007 is remembered. And if current conditions hold, 2008 could also qualify.

Why? Consider what’s occurred in the UK over the past 18 months. The excesses of sub-prime lending came home to roost. Credit and lending tightened. Banks faced unprecedented challenges and dramatic rescues. Housing construction tanked, as did existing home sales. Fuel costs surged. Inflation threatened to spread across sectors. The economy, in short, turned anaemic.

Yet, for the most part, the waste management industry seems to have escaped its most severe impacts. Indeed, in the recycling sector, recent business conditions have been strong – the result of unprecedented worldwide demand for commodities and stratospheric market prices. While it’s far too soon to celebrate – the economic dangers are not yet over, and significant and ongoing challenges remain – the industries seem to be holding their own in terms of profitability, and industry experts are optimistic about future performance.

The waste management industry keeps rolling

‘This industry is inherently what you would call “recession resistant”’, says Liley Mehta, a credit rating analyst who has covered the waste management industry for Standard & Poor’s since 2001. The waste collection, transfer and landfill disposal businesses comprise a mature, slow-growth industry whose core performance doesn’t vary a lot from quarter to quarter, or year to year. ‘You have a pretty steady amount of garbage, no matter what is happening with the economy,’ Mehta observes.

The US industry has traditionally been dominated by three sizeable gorillas, publicly-traded Waste Management Inc. which is the biggest, plus Republic Services and Allied Waste. Interesting developments are set to take place though, as following a merger announcement between Republic and Allied, Waste Management put in a bid for Republic and at the time of going to press the offer had been rejected. These top three firms are followed by other investor-owned waste companies, municipalities and roughly 4000 small, privately held firms.

The three leaders turned in decent financial performances in 2007 despite an economy that began souring late in the year. Revenues for Waste Management Inc. – by far the largest environmental service company – reached $13.3 billion in 2007 but fell 0.4% short of the previous year. Allied and Republic, plus Casella Waste Systems and Waste Connections (the fourth and fifth largest companies in the industry, respectively), reported revenue gains ranging from 2.7% to 16.3%.

As a whole, revenues for the waste collection industry rose 4.5% to $39.87 billion, says George Van Horn, senior analyst for IBIS World, a Los Angeles-based industry intelligence firm that analyzes several sectors worldwide. Industry revenues grew despite slipping total solid waste volumes, the manna of the industry. Waste Management’s volumes decreased 4.5%, for example, while Allied Waste dropped 3.5% and Republic Services fell 1.6%.

Volumes fell for several reasons, but primarily because of the decrease in the amount of construction and demolition roll-off waste. Of the roughly 135 million tons (122 million tonnes) of C&D waste generated annually, about 30% comes from new residential and commercial construction. And US residential housing starts slumped 26% in 2007. Waste generation grew more slowly than the economy, which grew just 2.2% in 2007, comments S&P environmental services analyst Stewart Scharf, author of the company’s Waste Management Industry Survey. The lagging economy held back industrial and municipal waste volumes.

One of the revenue bright spots came from growth in recycling volumes – including paper and paperboard, recycled plastic and aluminium. Among others, recycling operations for Waste Management and Allied benefited.

Reducing cost pressures

The waste industry was able to offset reduced revenues and higher costs in 2007 by imposing special fuel surcharges, environmental fees to cover higher regulatory compliance costs and overall price hikes for customers, on both the collection and landfill sides of the business.

‘With rocketing oil and diesel costs, fuel is one of the critical problems that the industry faces’ says Gene Wingerter, an investment banking consultant who chaired what is today’s Environmental Industries Association. ‘The only way to sustain (profit) margins is to pass along that added fuel cost.’ To cut costs, the industry has also slashed jobs, divested unprofitable businesses, strengthened employee safety programmes to reduce insurance claims and premiums, and improved maintenance programmes to reduce repair costs for its truck fleets, according to S&P analyst Scharf.

With many companies controlling their own landfill and disposal operations, Scharf says more volumes are being steered to company facilities and the major players ‘have participated in asset swaps to acquire landfills that are closer to their major routes.’ Even as the number of landfills continues to dwindle, landfill capacities aren’t a problem. ‘In terms of landfill life and availability, the big players are well positioned. Their landfill life runs into decades,’ Mehta says.

While Wingerter sees a continuing long-haul waste transfer to landfill sites in Kentucky and West Virginia with more competitive rates than those in the dense metropolitan areas, the increase in fuel costs and traffic congestion may lead companies to examine alternatives and efficiencies. Another trend, according to Van Horn, is the growth in local government agencies outsourcing waste collection and management to private operators.

Smaller, select acquisitions are in vogue

Mergers and acquisitions are still in favour – but only with very select deals. Unlike the merger frenzy of the 1990s, waste management companies have been pursuing smaller, targeted acquisitions that make strategic sense. ‘The public companies are still doing acquisitions, but by and large, the last big phase of consolidation among the publicly-traded companies was in the 1990s. And I would say they have been in a period of digestion since,’ comments Craig L. Farlie, a partner with the Florida investment banking firm Farlie, Turner and Co.

Companies have been working off the uncomfortably high debt levels remaining from the 1990s consolidation binge. Stronger companies are also using free cash flow to buy back shares, boost earnings per share and increase dividends, to return earnings to shareholders. They’re also still buying companies, but in a more targeted way. They’re acquiring to fill a waste management niche. They’re using acquisitions to move into new business areas, as Waste Management did with medical waste. They’re finding adjacent territories that complement and strengthen existing operations.

The waste industry’s predictable cash flows and strength through downturns has caught the attention of private equity firms. ‘You are seeing large pools of institutional capital – private equity firms – start to compete for and often win acquisitions,’ says Farlie, who hosted a conference on private equity investment at a solid waste exposition this year.

While the meltdown of financial markets last summer brought M&A activity ‘to a standstill’, according to S&P credit analyst Mehta, several private equity transactions have been completed. For example, Goldman Sachs helped take Waste Industries private in a major transaction. Center Partners purchased the privately held New York company Liberty Waste. Private equity also played a large role in the sale of a large privately-held company in the Midwest and a public company in the UK.

Given the weakness in the US dollar against other world currencies, Van Horn says it would seem the environment is ripe for waste industry acquisitions by foreign-based companies. ‘From a currency standpoint the attractiveness of looking at US assets has changed significantly and makes an awful lot more sense relative to where things were five years ago,’ Van Horn observes. ‘If a foreign operator wanted to establish a position in the US right now, given the currency rates you could say that the US is on sale.’

Technology focuses on boosting efficiencies

Gene Wingerter was surprised at one of the advances he witnessed at a recent waste industry exposition. ‘We saw a hybrid truck for the first time,’ says Wingerter, who is former waste advocacy group chairman. It was a chassis designed specifically for heavy-duty operations such as those encountered in the waste management industry. There was much innovation on display, including solar panels to help power waste compactors.

‘Anything related to efficiency, to reduced costs of operation, reduced fuel consumption, is going to be the wave of the future,’ he says. Companies are replacing their fleets with diesel trucks that meet new EPA emissions. They’re switching to efficient bio-diesel. Managements are increasing efficiency by investing in collection trucks with automated side loaders and equipment that minimizes the need for an extra crew member. Trucks are getting satellite tracking and computer technology as well, so management knows ‘where the fleet is at a given time and knows what it is doing,’ says Van Horn. Such technology enables companies to ‘consciously weed out’ unprofitable customers and drive pricing levels says S&P credit analyst Mehta.

At the other end of the spectrum, says S&P, companies are building waste-to-energy plants that capture and burn energy-rich landfill gas for power generation. Waste Management has 16 such plants and has plans for 60 more; Casella Waste Systems, based in Vermont, plans to build generating facilities at six landfills.

The waste industry’s 2008 outlook

Analysts believe that there will be more economic pain, because gross domestic product is expected to grow a scant 1.1%. Housing will continue to be in the doldrums. It’s expected new housing starts will drop another 36% in 2008 from the depressed levels in 2007. That will further depress construction and demolition waste volumes and hit regionally-based operators.

‘If a geographic market has been extremely sensitive to overbuilding in housing, then the smaller player is going to be affected more than the larger players who cover a much wider swathe of geography,’ says IBIS World’s analyst Van Horn. Mehta says some smaller, regional waste management companies are more vulnerable than the national, more well-diversified operators because of higher debt, disproportionate exposure to reduced waste volumes and other potential difficulties. At the other end of the spectrum, the Goliaths in the industry ‘are well positioned and continue to be strong in terms of steady (profit) margins and good cash generation,’ she indicates. 
While 2008 could pressure profits because of lower waste volumes, ‘the companies have all indicated that they will be pushing through price increases,’ Mehta says. ‘So, overall for the big players, I still expect profitability to hold up.’

Positive business conditions fuel recycling and commodities companies

Eric Glover, an equity analyst for San Francisco-based Canaccord Adams, paints an almost once-in-a-lifetime positive portrait of business conditions in the recycling and scrap sectors. ‘These are the best times ever for scrap companies in terms of overall profitability,’ Glover says. ‘If you’re already in business, you’re at the right place, at the right time.’ He points out that the companies that buy, bundle, collect and process recyclable materials are finding themselves at the confluence of several economic trends that have spurred insatiable demand and significantly higher prices.

While the US economy is chugging ahead, emerging economies are racing forward at rates many times America’s pace, according to Robert J. Garino, director of commodities for the trade group Institute of Scrap Recycling Industries. Garino points out that China’s economy expanded 11.4% last year; Russia’s growth was 8.1%; India’s 9.2%.

Higher international demand and steady domestic demand, Garino says, has been felt for consumer-recycled commodities such as aluminium, paper and cardboard, and plastic. Likewise, there’s been very high demand for scrap ferrous metals (various grades of steel, for example) and non-ferrous metals (such as copper, nickel, lead and zinc). Increased economic activity is one explanation for growing ferrous scrap demand. Changing technologies – at least in the use of ferrous scrap – is another. Countries worldwide are building more efficient mini-mills to make steel, instead of the traditional blast furnace and insead of using raw materials operators are using scrap.

Russia and Eastern Europe are shifting from being scrap exporters to being scrap importers,’ Glover says. ‘They’re facing their own supply shortages, and that’s drawing greater demand from the US. Thus, scrap exports from the US have gone up very significantly, and should reach another record this year.’

Yet scrap supplies in the US are under pressure, Glover explains. The American manufacturing base is shifting overseas – thus, taking associated industrial scrap with it. US automobile production, another source of scrap by-products, is also weaker as fewer cars are made at home. ‘(Supply) is an ongoing problem for the industry,’ Glover contends. ‘You can’t pull scrap out of the ground, like you can drill for oil in deeper waters. There’s only a limited amount of scrap out there. If you’re not producing as much or don’t have enough scrap, it’s a big problem.’

The tight market is illustrated by the price for number-one-grade heavy melting steel (1 HMS). It’s up 80% so far in 2008 to $500 per ton (0.9 tonnes), and it has increased fivefold since the year 2000. The price of alternatives and rising energy costs contributed to higher scrap prices. Exports of ferrous scrap rose 23% over 2006 to a record 13.7 million metric tonnes, says Garino. Worldwide steel production set another high at 1.34 billion tonnes, with China leading output with nearly 500 million tonnes – close to five times the amount produced in the US.

Scrap companies with existing inventories benefited most, Glover says. They had to pay more for their ‘feedstock’ – but ‘as margin percentages have gone down, margin dollars and earnings have gone up considerably,’ Glover maintains. Some of the smaller scrap producers might have difficulty with having sufficient working capital, as the costs have risen so dramatically. The financial performance of the major investor-owned American scrap companies was good. Metalico revenues rose from $207.7 million to $334.2 million in 2007, profits increase by half to $14.8 million. Industrial Services of America, a smaller US processor, saw its recycling business expand 28% and overall profits rise 17%. Sales for Sims Group’s US operations were up 27%.

Commodities influenced by Chinese demand

The story for demand and pricing was very similar for other commodities in 2007, according to Garino:

China’s share of global manufacturing output is estimated to be just shy of 15%, according to the Financial Times, with the US still the world’s leader at just under 25%.

Acquisitions to assure supplies

With scrap inventories reportedly at their lowest levels in 60 years, two of the largest American mini-mill steel makers – Steel Dynamics and Nucor – both acquired large scrap companies to shore up supplies and vertically integrate operations. Steel Dynamics purchased OmniSource, a scrap processor with 42 American locations. Nucor bought David A. Joseph Company, which in 2007 brokered 20 million tons (18 million tonnes) of ferrous scrap and more than 500 million pounds (226,800 tonnes) of non-ferrous materials. ‘Despite the talk about the US economy, the demand for US steel remains pretty decent,’ Glover says.

Australian scrap company Sims Group entered the US market – still the world’s largest scrap market – by purchasing Metal Management. That extended its presence from the north-east into the mid-section of the country. Sims also started a joint venture with a California recycler. Glover contends that scrap companies themselves have merged to gain better negotiating leverage and control over where to sell and ship their products, with access to American shipping ports being a key factor in a merger partner.

Where are trends heading?

It looks like more of the same for 2008, according to the experts. The overall economy is slow but may rebound slightly. China, India, Brazil and other emerging markets will continue to be a demand factor regarding the sourcing of scrap. ‘So our position is that the days of cheap scrap are long gone,’ says Glover. ‘It’s very similar to gasoline prices, where $2 a gallon, and even $3 a gallon, feels like ancient history.’

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