Three years into the economic recovery, 2012 opened with thoughts of better pricing discipline and improving volume trends. Even paper prices, which had dipped late in the second half of 2011, were showing signs of a seasonal lift early in the year. Added to the mix was the idea that capital gains taxes were going up. It was not a question of if, but when and by how much. With that backdrop 2012 was expected to be one of the most active deal cycles in many years. Veolia’s late 2011 announcement that it was selling its U.S. solid waste operations only added to the chatter.
By the time 2012 closes out, price discipline will be back and the volume trend should be less negative, centering around flat growth with a positive bias. The year could even finish with a flurry of activity as there is a push to close deals. However, the path to this outcome was anything but smooth.
In the first nine months of 2012 the companies in the publicly traded group completed two equity offerings totaling $416 million, refinanced more than $1.47 billion in debt, with the debt market practically giving money away. The group lowered guidance six weeks after first providing it, only to then reaffirm revised guidance at the upper end before finally reducing the full-year outlook as paper prices steadily fell to $85 per ton in September.
For most of the year the fiscal cliff and sequestration were distant concerns. Now they dominate the national and financial press. The best case, in the near-term, is for Washington to leave the current tax rules in place and then come back after the inauguration and hammer out real change in social programs, the tax code and the deficit. Without that outcome, U.S. gross domestic product (GDP) is trapped in low growth of 2 percent to 3 percent. Specific to solid waste companies is the probability of bonus depreciation being extended and the level and timing of increased capital gains taxes.
Volumes not as negative as reported
Following the steep volume decline in 2009, scale reports in the small container business remained negative in 2010 and 2011. Housing starts continued to decline and new business formation was all but stalled. In 2012 the pattern clearly showed signs of improvement with small container weights less negative, even positive in some markets. Housing starts posted 11 months of positive year-over-year comparisons, albeit off a low base. Housing starts above 1 million are needed to create a broad-based volume step up. However, housing starts of 650,000 to 750,000 clearly help ease the pressure of a low-growth economy.
Muddying this picture was the special waste market (mostly dirt). Federal stimulus funds prompted accelerated government spending in 2011 making for tough comparisons in 2012. So while municipal solid waste (MSW) and construction and demolition (C&D) trends were improving, reported volumes looked progressively worse in the middle quarters of 2012. Despite this noise, landfill volumes are flat with rising tip fees, another sign of a increased stability in the underlying solid waste market.
Intense price competition begins to ease
Unlike the prior three recessions there has been no meaningful housing recovery from the 2007 recession. Nor has there been any substantive new business formation. Empty storefronts in strip malls are the norm rather than the exception. It’s no wonder that the commercial container market witnessed a marked increase in poaching each year. That led to a behavior of defending business and the downward pressure on small container prices one customer at a time.
In 2012 the volume picture began to improve and the intense competition in the small container market started to ease by the second half. It should be noted that the consumer price index (CPI) resets booked on July 1 held into the third quarter of 2012 and were not lost through competition, adding further evidence that small container competition is easing moderately.
A different dynamic has been driving rates lower in the municipal market. In the United States, municipal contracts tend to be held for 10 to 15 years, with an average of 12 years. Over that period those contracts have supported an annual CPI-based price increase. Unless a significant service breach has occurred most municipalities would rather renegotiate a contract price reset as opposed to rebidding, avoiding the political ramifications of service interruptions from changing vendors.
When cycles of rebidding have occurred they’ve been driven by either a very tough economic period or a political change. As 2012 ends, the cycle of renegotiations/rebids seems to have run its course. While 2013 will have the headwinds of lost 2012 business in one period it should also have offsetting wins starting up in others. It is up to the public and private companies to make this information clear to the stock market or potential buyers.
Paper prices: The tail wagging the dog
Solid waste is supposed to be a business that is highly predictable and sustainable, repeatedly producing loads of free cash flow. These fundamental characteristics remain true, with 85 percent to 90 percent of revenues recurring day in and day out. However, as recycling gains in scope, commodity pricing has introduced volatility. Paper prices typically have a seasonal pattern rising in the spring, dipping in the summer, rising again in the fall and dipping over the winter.
That pattern was disrupted in November 2008 and appeared to return in November 2011. In between, paper prices traded in a band in 2009 only to spike in 2010 with the expiration of the black liquor alternative fuel tax credit and as new paper making capacity came online late in 2010 into 2011. Then in November 2011 paper prices dipped, held steady over the winter and then lifted in the spring, all reminiscent of a normal seasonal pattern.
However, over the summer paper prices started a steady decline suggesting a more secular change, eventually bottoming at about $85 per ton, only to lift when International Paper announced a linerboard increase in late September. The threat of a longshoremen’s strike prompted a spike in paper prices on October 1st and that price rebound has stuck, rising through November even though the strike was postponed to January 1, 2013.
New paper making capacity using recovered fiber as a feedstock is expected to start up in 2013 in both China and the United States. At this point it appears the market is supporting higher prices and inventory builds to allow for new capacity and to be positioned in case the longshoremen’s strike does occur at the start of 2013.
Fuel prices are rising again
Way back when (pre-2004), fuel was 3 percent to 4 percent of revenues. Then diesel prices spiked and have never come back down. Today fuel is 6 percent to 8 percent of revenues and the industry has put in place fuel surcharges to pass through moves in fuel.
In 2012 fuel started the year at $3.78 per gallon and is likely to end the year at or above $4 per gallon. If diesel holds at $4 per gallon for all of 2013 it will be essentially flat with a 2012 average of $3.97 per gallon. That would mean a fuel surcharge in the first half of 2013 of up to 50 basis points is likely, supporting the overall price momentum in the collection and disposal markets at the start of the year when core price increases are usually passed through to the customer base.
Fuel surcharges are now so much part of the invoicing process, like environmental fees, that they’ve begun to help reinforce core price increases too. So while there is often a lag between a rise in fuel price and offsetting surcharges, the customer base has become conditioned to expect a surcharge. More and more solid waste collection companies are seeking to fold part of or the entire fuel surcharge into the base price. This scenario also supports better price momentum into 2013.
2013 Poised to be better than 2012
Barring fallout from the “fiscal cliff/sequestration” scenario plunging us back into a recession, collection and landfill price and volume trends are exiting 2012 with positive momentum. Reported price should range 2 percent to 3 percent and volume should be positive in a range of zero to 1 percent.
Sellers, if predisposed to do so, are likely to act, as capital gains taxes will be higher next. It’s just a question of how much and when. For a 10-point increase in capital gains, deal valuations have to improve by a full multiple turn just to be even on an after-tax cash basis. However, do not look for much deal activity until the second half of 2013. If capital gains was driving a sale that would have happened in 2012.
If bonus depreciation is not extended it is probable that capital spending will be less, with the truck/container market the most exposed to lower spending. Landfill expansions do not qualify for bonus depreciation.
All in all 2013 starts with a foundation of stability. It should be a year that solid waste regains its “mojo” proving to the markets that it is a highly predictable, repeatable business with robust free cash flow generation.
Michael E. Hoffman is the managing director for Wunderlich Securities, Inc.