The publicly-traded solid waste companies are on the verge of reporting 2017 year-end results and presenting their 2018 outlooks. In this month’s edition of Business Insights, we continue our tradition of sharing our thoughts on the outlook for the key drivers of the solid waste industry.
Pricing and Volume Trends Continue to Look Solid
Solid waste companies are again likely to issue pricing forecasts that are in line with their 2017 targets, particularly given the pricing stability that has characterized the past year. Waste Management (WM) and Republic Services (RSG) are expected to stick to their prior yield goals of 2 percent, but it is probable that RSG could range that up to 2 to 2.5 percent given its year-to-date performance of 2.4 percent. The core pricing target for Waste Connections (WCN) is likely to remain in a 2.5 to 3 percent range, with greater comfort expressed for the high end of 3 percent, as the company is still pushing price on the underlying Progressive Waste (BIN) assets. Casella Waste (CWST) is likely to consolidate and sustain the pricing gains over the past several years in a range of 2 to 2.5 percent. Advanced Disposal (ADSW) is likely to reiterate its longer-term price target of 2 percent, though that’s a stretch for all 2018 from the recently reported price in the third quarter of 0.2 percent. Full-year 2018 is more likely to come in around 1.5 percent. The companies’ pricing efforts are finally being supported by a more inflationary environment, which will aid consumer price index (CPI)-linked price contracts in 2018, at last providing a pricing tailwind. By all reports, pricing discipline among the private haulers is largely holding as well.
Although company management teams have verbally talked about potentially higher volumes as a result of stronger GDP stemming from the new tax law, it is unlikely that they will “bake” it into forecasts. Within a (still) estimated underlying 1 to 2 percent industry volume growth environment, most of the companies are likely to come in with ranges encompassing the midpoint, averaging around 1.5 percent, while expressing confidence in the underlying fundamental conditions and likely citing potential upside from a stronger economy. WM and RSG, in particular, should also have a benefit from weather-related volumes early in the year. CWST may end up closer to 1 percent due to the continued drag from the Southbridge, Mass., landfill.
Recycling Results Remain a Wildcard, While Fuel Has Begun to March Higher
In past years, old corrugated cardboard (OCC) has been used as a proxy for recycled commodities, and similar to the way that the solid waste companies have traditionally budgeted, January pricing is usually compared to the average for the prior year to get a baseline outlook. According to RISI data, the January 2018 Yellow Sheet average for OCC was roughly $105 per ton, a 24 percent decrease from the 2017 full year average of $138 per ton. Based on just that, recycling will be a drag on industry earnings in 2018. However, that figure hides even greater potential volatility than normal in the recycling arena. OCC pricing rose steadily through the first three quarters of 2017, though peaking at $167 per ton in July, when the first Chinese proclamations came out. (For more details, see our December Business Insights.) OCC swooned to $97 per ton in October 2017 before almost eerily stabilizing right around $105 per ton for the last three months. However, that recent stability hides heightened uncertainty in the marketplace right now. As of January, mixed paper and a number of types of plastics were banned, while the 0.5 percent contamination standard is slated to take effect in March. Updates on the early results of the ban are expected when the companies report results, but the ultimate impact of the very low contamination standard, and how strictly it will be enforced, will remain a wildcard. On the third quarter conference calls, a number of the players estimated the recycling business’s impact for 2018, with RSG putting the headwind at $0.04 to $0.05 and WM at $0.04. Based on the currently stable prices since then, but no relief from the 0.5 percent standard that had been hoped for, estimates for the impact from recycling are expected to be consistent or slightly worse. The February 2018 Yellow Sheet was just published, and on average, OCC dropped over $10 per ton from the January average, likely putting further downside pressure on recycling estimates.
On a simpler, more straightforward note, diesel prices began to rise in the second half of 2017, with a steeper increase occurring in the fourth quarter and January. Based on January diesel costs, fuel costs would be up on average 13.5 percent in 2018 over 2017, with increases in the range of 15 to 20 percent in the first three quarters of the year. But, if the increases remain measured, the companies generally recapture the cost fully (though with a small time lag), primarily through fuel surcharges.
Margin Guidance Likely to be Up
Despite the headwinds of recycling and fuel, margin guidance is likely to be modestly up. The CPI tailwind to price and solid volume expectations underpin stable margins, while perhaps more importantly, a number of company-specific cost items such as legal and landfill costs for RSG and healthcare and storm costs for ADSW should begin to ameliorate and provide easier comparisons. WCN forecast 50 basis points of EBITDA margin improvement in 2018, even with the anticipated, negative recycling hit of 50 basis points.
Earnings and Free Cash Flow to Track Materially Higher on Tax Cuts
As discussed in January’s Business Insights on the new tax law, the larger solid waste players like RSG and WM, and to a lesser extent WCN, are expected to be major beneficiaries of the new tax law on both an earnings and free cash flow basis. More specifics as to the extent of the benefits should be forthcoming on the fourth quarter conference calls. Of particular focus for financial analysts, however, will be how the underlying earnings of the companies compare to expectations. Based on all the aforementioned factors, it is likely that the solid waste companies will meet underlying expectations (in essence EBITDA forecasts) for 2018.
Expect More M&A but Higher Capex as a Result of the New Tax Law
As seen in other industries and in specific companies that have already reported earnings, many companies are announcing some type of increase in capital expenditures (capex), utilizing at least a portion of the benefit from lower expected cash taxes. This is also likely to be the case for the solid waste industry, particularly in light of China’s recent actions. Although the outlook for capex before enactment of the law was for fairly stable spending, a combination of continued strong volumes (resulting in more truck and container spend), a focus on reducing recycling contamination (resulting in the purchase of more optical sorters and automated systems), a greater overall investment in technology and the need to deal with persistently higher leachate costs at a number of the companies will probably result in higher capex than had previously been forecast, which will now be eased by the lower cash tax windfall, especially for the larger players. So far, just WM has announced a bonus for employees not on a sales incentive or bonus plan as a result of the law and as a retention effort.
The tax reform law is also likely to cause an already expected active merger and acquisition (M&A) environment to percolate even more. Besides the added cash on hand to spend, the tax law can also make transactions cheaper, as a result of the full expensing of certain capital investments, and the fact that the step-up issue, which been a hindrance on certain deals, is less of a concern. CWST has already almost met its 2018 acquisition goal with its recently announced acquisitions in the Northeast.
Leone Young is the principal of LTY ERC, LLC, providing consulting and research services to, and conducting special projects for, the environmental services industry, primarily the solid waste sector.