We stepped away from our “Own a Garbage Stock” thesis briefly in 4Q17 to let the market absorb the impact of plummeting commodity prices. However, it should come as no surprise to anyone who follows our research that we would revisit the group if underlying macro fundamentals of positive and improving GDP and CPI, (Figures 1 and 2), coupled with rising housing starts (Figure 7), which drives new business formation, were all supported by healthy consumer engagement (Figure 3).
Solid waste should be a core holding and investors should trade around the position: overweighting when going defensive, underweighting when deep cyclicals and financials are in favor, and market weighting otherwise. Solid waste is attractive at 4 percent to 5 percent FCF yield, demands new money be put to work over 5 percent FCF yield and becomes a source of funds below 4 percent FCF yield, in our view.
Solid waste stock performance over the past three years has been very good (Figure 5), resulting in strong multiple expansion (Figure 6). We do not believe solid waste fundamentals have peaked; this is supported by total housing starts, which, though improving, are still below a sustainable average of 1.4 million to 1.5 million starts (Figure 7).
We have completed three surveys: in late 2016 (survey #1), early 2017 (survey #2) and now late 2017 (survey #3). We conducted the first survey to establish a baseline of data to provide insight on the trends underlying the solid waste industry. Like the first two surveys, this one was conducted in conjunction with Waste360.com and distributed electronically to both its digital database and attendees at WasteExpo. Waste360 is a division of Informa, the international business intelligence, academic publishing, knowledge and events group.
The first survey had 413 respondents, of which 256 were highly correlated to the public company peer group. The second survey had 510 respondents, of which slightly more than half were highly correlated to the public company peer group. The third survey had 706 respondents, with about half correlated to our public company coverage peer group. All three surveys more than exceeded the response levels needed to have statistically determinant results.
The pool of respondents was very similar in all three surveys, with the mix of collection and disposal, or fleet composition, nearly identical. Over the course of the three surveys, the collection mix was split: about 35 percent to 40 percent commercial; 40 percent to 45 percent residential and low-20 percent roll-off. Overall, in survey #3, solid waste operations were split 67 percent collection, 11 percent landfill, 13 percent recycling and 9 percent other.
The fleet mix was nearly identical over the three surveys as well, with 48 percent front-end loader (FEL), 37 percent automated side loader (ASL) and 52 percent rear loader in the most recent results. A notable change was operators offering recycling on the same collection route dipped to 30 percent from 35 percent in survey #2 (compared to 25 percent in survey #1). However, the recycling processing mix was mostly unchanged, with more manual than automated collection.
On pricing, survey #3 results show residential average pricing is shifting higher, but with a smaller proportion making a change (34 percent of respondents raised rates vs. 45 percent in survey #2). The average blended rate/month per household remained about $15, as low priced residential (less than $10/month) accounted for 24 percent of respondents. It is hard to imagine how a collection operator can generate a reasonable return on capital below $10/month per household.
More collectors are offering a separate recycling pick-up, but that also means the average rate per month charged dipped versus survey #1 and #2. Over 50 percent of respondents suggested they were covering the real cost of recycling. However, they also offered the cost should be more than $7.50/month per household, which conflicts with the average charge per household of $4.20/month, down from $4.50/month in survey #2. About 80 percent of respondents, compared to 70 percent in survey #1 and #2, are not covering the cost of recycling collection based on the actual price/month data.
There is clear evidence FEL price/yard has increased in survey #3, with 23 percent and 26 percent of respondents in a range of $3.50 to $4.99 per yard for both existing and new customers, compared to 21 percent and 31 percent in surveys #1 and #2, respectively. FEL prices were up for 47 percent of respondents in survey #3, versus 42 percent and 53 percent in surveys #1 and #2, respectively. Also in survey #3, 47 percent of respondents with temporary roll-off increased price, compared to 39 percent and 41 percent in surveys #1 and #2, respectively.
Volume trends remained positive, with 65 percent of respondents in FEL increasing the service interval in the past six months. Roll-off pull frequency increased for 52 percent of respondents. MSW trends were on the rise in survey #2, and that trend continued in survey #3. The source of volume has changed, with more landfill volume (57 percent in survey #3 versus 48 percent in survey #2) from third parties.
Only 44 percent of respondents in survey #3 believe the recycling model will shift to a process fee. About 78 percent of landfill operators are not adding price or are doing so at less than inflation, and 40 percent of respondents have landfill volumes up. Only 24 percent of respondents do not have landfill volume come through a transfer station.
The survey #3 results on their own show a bias to improving trends across the industry. Compared to survey #1, the industry is sustaining a favorable shift on price. Also, the underlying volume outlook picked up in survey #2, and, while the cycle is showing some signs of maturing, it remains positive and the mix is toward more MSW.
This pattern is consistent with a slow, but steady recovery in housing and non-residential construction and the corresponding leverage of positive consumer engagement. The public and private service companies are far more disciplined about growth capital deployment, and that is supporting better pricing trends in collection and suggesting early signs of better disposal pricing trends too.
A mix shift to more industrial collection as a percentage of sales is a clear indication of a positive construction cycle, and also reinforces favorable consumer behavior in the past year (Figure 9) as well as the prospect of new business formation, which would drive more commercial collection growth. From survey #1, a spike in roll-off vehicle purchases led to a lift in FEL vehicle buying in survey #2, as new household formation drove new business formation. Could the trend of stronger FEL sales repeat in 2018 (something to look for in survey #4) on stronger temporary roll-off activity?
Residential pricing trends per household have improved for 34 percent of respondents, compared to 45 percent in survey #2 and 30 percent in survey #1 (Figure 11). The average monthly rate per household has bifurcated, with 48 percent over $15/household, but 24 percent at less than $10/household, a sharp increase from 19 percent in survey #2. This spike at the lower end in survey #3 is holding the overall average at about $15/household. We believe the slower pace of change in price (34 percent in survey #3, versus 45 percent in survey #2) is more a function of timing than a lack of price leverage because most residential work reprices on an index in late 2Q or the start of 3Q.
Pricing in commercial collection is clearly rising, and the pace of that change has not matured yet, with 35 percent increasing price in survey #3, versus 27 percent in survey #2. Even more significant is 36 percent of respondents continue to see average weight per yard rising, which should support high margin incremental service interval upgrades in the future (Figure 16).
In survey #3, the mix shift to a price of over $5/yard for existing customers was meaningful. In survey #3, 26 percent of respondents reported prices at this level, compared to 21 percent in survey #2 (Figure 13). There was, however, no meaningful change in the mix of respondents at $4/yard or more between survey #2 and #3. The trends were even more significant for new customers, with the data suggesting the discount to add a customer compared to existing business is nearly nil (Figure 14).
Volume trends coupled with commercial business mix as a percentage of sales support service interval increases, with 19 percent posting a 2.5 percent or better volume increase in survey #3, compared to 14 percent in survey #2 and only 10 percent in survey #1 (Figure 16).
Roll-off – Temporary and Permanent
Both permanent and temporary roll-off activity supported better price trends in survey #3. This was consistent with the favorable data in survey #2 for permanent roll-off, and better for temporary roll-off when compared to surveys #1 and #2 (Figures 17 and 18). The temporary roll-off data suggests the construction cycle remains favorable, which is consistent with the non-residential and housing outlook laid out in (Figures 4 and 7).
The data on roll-off pulls in the temporary market (C&D and Special Waste) suggest the trend remains positive and show an increase in activity compared to survey #2, as 52 percent of respondents indicated increasing pulls, compared to 43 percent in survey #2 and 48 percent in survey #1 (Figure 19).
Recycling/Material Recovery Facility (MRF)
Whether a solid waste operator, resident or politician, all want or are willing to support recycling. In survey #3, 89 percent of respondents stated they offer recycling either on the same collection route or separately (40 percent of respondents in survey #3 specified a separate collection, compared to 29 percent in survey #2). Regarding the recent moves by China, nearly 50 percent of respondents say the lower contamination standard will impact where they sell recycled fiber and nearly 40 percent of respondents stated they export over 30 percent of recovered materials.
The data also suggest the fundamentals remain poor and have even deteriorated. Processing cost per ton has gone up in the latest survey, not down, with 68 percent over $70/ton, compared to 63 percent in survey 2 percent and 66 percent in survey #1 (Figure 20).
Capacity utilization has improved to 70 percent or better for 69 percent of survey #3 respondents, compared to 63 percent in survey #2 (Figure 21). Meanwhile, respondents reporting residuals at 15 percent or greater remained unchanged in survey #3, compared to survey #2. However, there was a clear shift on the low end, with 54 percent of respondents at less than 10 percent residuals in survey #3, compared to 40 percent in survey #2 (Figure 22).
Expenses and Capital Spending Trends
There has been a clear and evident shift by the solid waste industry to a focus on cash-on-cash returns, and it is driving behavior for both public and private solid waste operators. That draws attention to capital spending: how much is spent and on what. The mix of spending in survey #3 (Figure 23) reaffirms the growth spending trend that appeared in survey #2. The incremental dollar of spending is mostly for rolling stock—vehicles and containers—with technology for vehicles the next biggest focus at 20 percent of a new incremental dollar of spending (Figure 26).
The municipal markets seemed to pick up activity in survey #2, but that trend has eased again as the mix of rear-loaders in the capital spending data dipped. Roll-off spending is virtually flat, but automated side-loader (ASL) and front end loader (FEL) are down in survey #3, compared to survey #2 (Figure 24). Landfill cell development cost has shifted up to over $300,000 per acre (Figure 25).
Survey #1, which was conducted in late 2016, provided clear evidence of improving fundamentals in solid waste, and the fundamental and stock price performance of the group validated that outlook. Survey #2, which was conducted in early 2017, reaffirmed this perspective and showed evidence of the impact of more volume on pricing and capital spending. Survey #3 now reaffirms the favorable outlook for solid waste industry fundamentals. The fundamentals are improving, but some maturing is evident, given this is the sixth year since the positive turn in volume in 2012.
The public company solid waste group begins its 4Q17 earnings and FY18 guidance cycle soon. The survey results support both a good finish to FY17 and a continuation of improving industry fundamentals. We believe price and volume trends in FY18 should range at 1.5 percent to 3.5 percent price and 1 percent to 2 percent volume, with an economic back drop of 2.5 percent to 3.5 percent GDP and 1.5 percent to 2.0 percent headline CPI.
Spending remains prudent. This further supports price leverage, as operators are not dumping incremental capacity into the collection markets, but adding new routes prudently. We would describe the solid waste industry collection markets at virtual full capacity and caution that while there is a shift to some growth capital, it will be added selectively, with a clear eye on productivity, not just a capacity increase.
We do not see a change in capital allocation of the public companies following the clear cash flow benefit of tax reform, and we expect the historic proportional use of FCF (deals, share buybacks and dividends) to remain the same. Nor do we see the mix of capital spending shifting now that qualified spending will benefit from 100 percent accelerated depreciation. Yes, maybe some late 2017 spending was pushed into FY18 to take advantage of accelerated deprecation at 100 percent for five years, but that is different than spending more as a percentage of sales sustainably. We expect the public and private companies to take full advantage of accelerated depreciation. We do not believe total capital spending increases as a percentage of sales.
The Waste360/Penton Survey #1, #2 and #3 Waste Industry Sentiment Survey – Stifel has worked in partnership with Waste360/Penton to develop and distribute an electronic survey from Waste360/Penton’s digital database and WasteExpo attendee list. Waste360 is a division of Informa, the international business intelligence, academic publishing, knowledge and events group. Waste360/Penton was acquired by Informa in November 2016.
This report is prepared by Stifel and distributed with permission.