As 2016 begins, the outlook for the industry looks fairly strong, with positive signs for pricing, volume– and even recycling. But energy volatility will continue to cause struggles.
Holding the Line on Price with Positive Volume
In last year’s outlook piece, Business Insights highlighted the falling price of oil and its various impacts on the solid waste industry, and obviously, the continued fall in oil remains a large factor. However, in the midst of a volatile stock market, in part driven by fears of a global economic and industrial slowdown, it is likely that the inherent late-cycle characteristics of the industry will come to the fore, with positive outlooks for price and volume.
First, with regard to price, solid waste companies are likely to forecast consistent levels in 2016, despite another modestly negative (perhaps 20-30 basis points) impact from continued low consumer price index (CPI)-related pricing, typical in municipal contracts. That would imply core pricing of around 4 percent for Waste Management (WM) and yield in the area of 2+ percent for Republic Services (RSG). Waste Connections (WCN) targeted 4 to 5 percent organic growth in its third-quarter conference call, likely indicating pricing around 2.5 percent. Progressive Waste (BIN) guided to 2016 pricing of 1.5 to 2 percent. As a combined company, organic growth was projected to remain around 4 percent, split evenly between price and volume.
Industry volume seems to be honing in around 1 percent in 2016, likely with more upside than downside, though WCN may guide higher–1.5 to 2 percent. On a percentage basis, this represents a slowdown from 2015 levels, which ranged between 1.5 to 2.5 percent, but still signals consistent, positive growth. Again, the late cycle, more recession-resistant characteristics of the industry are likely to be in play, aided by household and business formation driven by the housing recovery.
Recycling Looks More Benign, While Fuel Remains a Tailwind
For the first time since 2011, recycling may prove to look more neutral to results in 2016, versus a headwind. Certainly, further commodity price declines remain a downside risk, particularly given lower oil prices’ impact on plastics and China’s weak demand on metals. But the recycled paper market looks more stable, albeit at very depressed levels. Although paper represents less of the recycled material stream than in the past, old corrugated cardboard (OCC) pricing remains a major benchmark used in solid waste company recycling budgeting.
Projecting December levels into 2016 (admittedly a very artificial construct), would imply a fairly neutral average price level in 2016 versus 2015. According to RISI, average December OCC pricing was just under $82 per ton, versus an average of $81 per ton for all 2015. It should be noted, however, that January average OCC pricing dropped to just under $80 per ton. Additionally, mounting anecdotal evidence of a consistent industry approach to reconfiguring contracts, raising prices on or restricting certain recycled commodities like glass, and cracking down on contamination levels will all result in lower operating expenses for the various companies’ recycling divisions.
As diesel fuel maintains its steady downward march, it remains a tailwind. Although the industry widely utilizes fuel surcharges, expenses are still falling first, and faster, than the associated revenues. For portions of the business not covered by fuel surcharges, lower fuel prices will be an unmitigated benefit all year, even if oil prices stabilize in here. Projecting current diesel prices (which are of course lower than at any point in 2015), would indicate that 2016 diesel pricing will be down another 23 percent from the average in 2015.
Of course, the flip side of this is the negative impact on the solid waste companies’ energy waste businesses. This is most notable for WCN, as its R360 division still represented 9 percent of revenues last quarter, even after its precipitous decline, but energy waste also will take its toll on WM’s and RSG’s earnings and margins, even though it represents only a couple of percentage points of revenues for both companies. Even BIN and Casella Waste (CWST), which have no direct energy waste exposure, have felt the slowdown in oil and gas production–BIN in western Canada and CWST in the Marcellus Shale.
However, with recycling and fuel likely to prove neutral to positive, and the impact from the WCN/BIN merger (discussed further below), energy waste does not look to be the black hole it was last year, particularly for WCN, as it will fall to less than 4 percent of the combined company revenues.
M&A to the Rescue…. and Internal Moves Help as Well
Not for the first time in the history of this industry, but particularly in this year versus the past several, mergers and acquisitions (M&A) will play a very beneficial role, particularly for WCN and BIN. WCN was unquestionably facing another shortfall in its energy waste business R360, while BIN faced a challenging margin target and timeframe to turn around its West operations, which had significant cost overruns in mid-to-late 2015.
With the announced merger agreement, both companies have gained considerable breathing room, significantly enhancing their abilities to make financial and earnings targets (and meet investor expectations). Financial expectations for the combined company have been set at very reasonable levels, and there could be substantial upside to the synergy target (estimated to be as much as double the initial $50 million synergy target)–potentially more than covering foreseen and unforeseen problems and shortfalls.
The merger is very akin to the RSG and Allied Waste merger in 2009. For the industry as a whole, the transaction is likely to strengthen industry pricing discipline, while the eventual disposition/swap of an estimated 10 to 15 percent of BIN’s footprint will possibly benefit WM’s quest to replace the divested Wheelabrator earnings before interest, taxes, depreciation and amortization (EBITDA) and RSG’s tuck-in acquisition goal.
RSG and WM have also been consistently augmenting revenue growth drivers with internal operating efficiency and cost cutting programs. Most recently, RSG took a more significant step in this regard with its announced reorganization. By flattening its management structure and removing the regional management layer, RSG anticipates saving $25 million annually. CWST also continues its more aggressive disposal pricing strategy and collection efficiency programs.
Positive Direction for Margins, Earnings and Free Cash Flow, Though Capex Looks Flat to Down
As a result of the confluence of all the above mentioned factors, the solid waste companies are in the enviable position (vis-Ã -vis Corporate America in general and industrial firms in particular) of being able to provide outlooks for generally expanding margins, continued earnings growth and higher free cash flow. RSG’s reorganization likely will enable it to expand margins after several years of downward margin pressure, and the preliminary EPS and free cash flow guidance calls for growth in the mid-to-high single digits, respectively.
Although WM is facing some free cash flow timing issues, due to an anticipated higher level of cash taxes in 2016, management recently noted that they believe the company’s “base” free cash flow has grown to $1.4 billion, up from the $1.2 billion to $1.3 billion level it had been for the last several years.
Given synergy expectations, a lower expected tax rate and safety and operational improvements, the combined WCN/BIN envisions an EBITDA margin of 32 percent in several years, up from 30 percent in year one, while also anticipating that the merger will enable BIN’s free cash flow conversion to come up to WCN’s level for the combined company–about 15 percent of revenues.
In 2016, capital expenditures, or capex spending for BIN (stand-alone) and CWST is anticipated to ramp down after several years of elevated levels. WCN also anticipates lower capex in 2016, as it pulled in capex spending from 2016 to 2015 in anticipation of bonus depreciation expiration. Bonus depreciation was extended by Congress in the 11th hour, which may influence spending patterns, but will certainly also enhance cash flow!
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.
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