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Waste Works
INITIATION
Initiating Coverage On The 3 Big Players
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We are initiating coverage on the Environmental Services sector with
an Overweight. We believe companies with significant landfill control will
leverage comprehensive and sustainable pricing increases across Collection
and Disposal lines of business, expanding margins and improving returns
while squeezing competing waste collectors lacking disposal assets. Should
pricing or volume trends prove stronger than currently modeled, the
opportunity could be greater.
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Accordingly, we initiate coverage on the three largest industry
participants: Waste Management, Inc. (Outperform, target $45);
Republic Services, Inc. (Outperform, target $35); and Allied Waste
Industries, Inc. (Outperform, target $16). With collective control of
approximately 60% of municipal solid waste landfill volumes, these
companies have emerged as the beneficiaries of years of consolidation and
will be the principal drivers of rational pricing behavior for the industry over
the long term.
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Waste Management, Inc., is our top pick given the company’s sheer
dominance in the marketplace. We expect WMI to focus on pricing and
reap sustained rewards from its Pricing Excellence initiatives along with
other operational improvements as it continues to lead the shift in industry
culture and pricing discipline. Strong free cash flow will provide flexibility for
increased dividends and enhanced share buybacks.
■
Allied Waste Industries, Inc., is a “middle-innings” turnaround story
that presents opportunity for patient investors willing to take on risk.
AW’s new management team has made substantial improvements to the
business over the past couple of years, and we expect gains in productivity
and pricing improvement to generate strong free cash flow allowing further
debt reduction and a narrowing of the valuation gap over time.
■
Republic Services, Inc., is the consistent performer within the space,
benefiting from favorable geographic market positioning and a less
volatile business mix. Indeed, Republic’s contract positioning offers less
downside risk in an increasingly uncertain economic environment while
allowing the company to capture the benefits of a pricing-led upturn and put
cash flow to work via share buybacks and dividend hikes.
Investment Summary
We are initiating coverage on the Environmental Services sector with an Overweight
position. Within the sector, we are initiating coverage on the three largest industry
participants: Waste Management, Inc. (Outperform, target $45); Republic Services, Inc.
(Outperform, target $35), and Allied Waste Industries, Inc. (Outperform, target $16). With
collective control of approximately 60% of municipal solid waste landfill volumes, these
companies have emerged as the beneficiaries of years of consolidation and will be the
principal drivers of rational pricing behavior for the industry over the long term.
We designate Waste Management our Top Pick, as the company continues to leverage its
sheer dominance in the industry to bring about a shift toward a more rational pricingdisciplined
culture focused on long-term sustainable returns. Allied Waste remains a
compelling multi-year turnaround story for patient investors willing to bear the associated
risks, as new management continues to make significant headway in operational rightsizing
and debt reduction initiatives. Republic Services remains the consistent performer—
with favorable geographic positioning in high-growth areas combined with a greater focus
on long-term contracts allowing the company to benefit from industry upturns while
remaining shielded on the downside.
Following a period of substantial integration-related initiatives and, admittedly, some
painful operational and financial missteps along the way, the Environmental Services
industry has largely right-sized itself and successfully made the transition to an internally
focused operating model versus previous years of acquisition focus. Accordingly,
strategies have been developed by new management teams with fresh perspectives on
the industry that now govern the behavior of the major players, and we believe this
presents sustainable opportunity for investors.
We expect the industry to maintain focus on pricing power across both collection and
disposal lines of business as companies abandon historical strategies of volume-chasing
in favor of optimizing profitability and returns. Recognizing the relative scarcity of landfill
assets in particular, we expect those companies that control landfills to leverage
comprehensive pricing increases in Disposal to expand margins and improve returns.
Smaller third-party collection service providers dependent on landfill owners will likely see
margins compress, as their own costs for disposing of waste increase—potentially putting
them at a competitive disadvantage and leading some to exit the marketplace altogether.
Consequently, larger players will gain market share in the midst of a more rational and
sustainable pricing environment.
Waste Management, Allied Waste, and Republic Services collectively control
approximately 60% of landfill capacity in the United States. Waste Management alone
accounts for a 30% share of landfill capacity. Such scale of landfill control positions these
companies well for leveraging pricing gains to enhance profitability while increasing costs
of disposal for smaller competitors—ultimately reducing smaller players’ competitive
presence in the overall marketplace and allowing the major service providers to continue
driving price.
Although a slowing economic environment could constrain volume growth and perhaps put
a slight damper on the magnitude of near-term pricing gains (our forecasts call for just 3-
4% consolidated price improvement for fiscal 2007 and 3.0-3.5% for fiscal 2008), we
believe upward pricing is here to stay—contrary to the market’s continued tendency to
discount the stocks whenever economic concerns surface. We view potential volumereactionary
moves in share prices as buying opportunities—as we expect patient investors
will see gains in pricing above inflation act as a buffer to cyclical tonnage declines. As our
sensitivity analyses indicate, conservative assumptions still imply favorable upside
potential. Should pricing or volume trend even stronger than modeled, the opportunity
could be greater.
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