The US non-hazardous solid-waste services industry generates annual revenue in excess of $50 billion, a staggering number just to keep our streets clean. Waste Management (WM), Republic Services (RSG), and Waste Connections (WCN) dominate this market, generating greater than 60% of industry revenues and controlling an equal percentage of valuable disposal capacity. The top line for the group can be expected to expand at a nominal-GDP rate, with pricing growth in the industry adding an additional tailwind thanks to recent consolidation (Republic Services/Allied Waste), a rational focus on return on invested capital, and cost pressures facing independent mom-and-pop trash companies and municipalities.
Operators generate strong and predictable cash flow. Within the collection line of a waste hauler's business, residential services provided to municipalities and individual households are on a service-based model (not-volume based) and can largely be viewed as insulated from economic pressures. Such a constant revenue stream helps to mitigate cyclical pressures in a trash taker's commercial collection and industrial roll-off lines, which also fall into the overall waste-collection category. Cell-by-cell landfill build-out provides additional flexibility with respect to capital outlays, as haulers can scale back expenditures during troubled economic times.
Year-to-date, Waste Management's third-quarter performance shows free cash flow (cash from operations less capital expenditures) of $1.03 billion, roughly 9.8% of sales, while Republic Services' year-to-date mark of $448.5 million represents 7.1% of sales. Waste Management more effectively converts sales to free cash flow, as capital expenditures (as a percentage of sales) are roughly 3 percentage points lower than those of Republic (7.9% versus 11%). We think Republic's capital requirements will steadily decline in coming years to a high-single-digit mark as percentage of sales once the hefty equipment expenditures of today are completed.
Transfer and disposal is the most lucrative revenue stream in the waste business. Landfill ownership can largely be viewed as the primary competitive advantage for a solid-waste operator. Though anyone that can finance a truck can bid on collection routes (service is undifferentiated), new entrants are at a significant disadvantage for disposal. For starters, building a landfill is expensive, time-consuming (permits can take 3-7 years to obtain, sometimes longer), and NIMBY (not-in-my-backyard) opposition has only increased with suburban sprawl. Subtitle D of the Resource Conservation and Recovery Act (1991) significantly increased the cost and complexity of landfill ownership (composite liners, leachate collection systems, zoning, etc.). As a result, many landfills in the US have been closed, and disposal airspace should only become more valuable over time.
Since collected waste must go somewhere (direct haul is only practical for 40-50 miles), the company that controls the disposal assets in a given "wasteshed" (locality) often dictates pricing. Owning the only dump in town also limits hefty tipping fees paid to other participants. Waste Management and Republic Services internalize -- dispose of into their own company-owned landfills -- more than 60% of collected waste, bolstering operating margins relative to privately-held, independent operators. Importantly, landfilling still represents the most prominent form of disposal, declining only 3 percentage points (as a percentage of generation) during the last decade. Materials recovery (including recycling) should continue its march upward, but the pace of this trend is far from tragic for the waste-hauling sector.
Waste Management's and Republic Services' third-quarter pricing trends certainly didn't disappoint. The former put up core pricing expansion of 3.9%, while the latter posted an average yield increase of 1.3% for the period. Though these numbers may not seem aggressive, they are quite meaningful across the large revenue bases of the two garbage giants. The commentary of Waste Management's CEO David Steiner regarding ongoing pricing expansion was particularly encouraging:
"In the third quarter, collection and disposal yield was 2.3%, the fifth quarter of sequential improvement, and nearly triple the yield we saw in the third quarter of 2012."
We're huge fundamental fans of the garbage hauling industry and hold Republic Services in the portfolio of our Best Ideas Newsletter. There's really nothing too frightening about the dividend health of Waste Management and Republic given their robust free cash flow, but we're not rushing to add them to the portfolio of our Dividend Growth Newsletter on the basis of their mediocre Valuentum Dividend Cushion scores (and hefty debt loads). Still, the structural characteristics of the garbage industry are among the strongest in our coverage universe given the value of landfill ownership. We're keeping a close eye on the group.
Additional disclosure: RSG is included in the portfolio of our Best Ideas Newsletter.