By Barbara Noverini
Large garbage trucks driving neighborhood routes are usually the most visible aspect of the waste disposal industry. However, the true value of this business resides in the ownership of landfills, in our opinion. Possessing an ample inventory of airspace to dump trash is a premium advantage that allows a landfill owner to reap outsize returns. Republic Services (RSG), Waste Connections (WCN) and Waste Management (WM) own a significant amount of U.S. landfill space, and this provides them with stalwart narrow economic moats. As regulatory barriers to entry constrain available landfill capacity and protect against competition, we believe landfill owners will be able to leverage their assets into robust results over the long term.
These large landfill owners deploy the unique aspects of their assets to sustain outsize returns despite the inherent constraints of a capital-intensive operational structure. With the ability to control pricing and leverage assets to drive profit expansion, we believe landfill ownership continues to be the key driver of outsize economic profit in the U.S. waste industry. Even though the shares of these major waste players are trading mainly in line with our fair value estimates, we believe a price pullback could offer an advantageous opportunity to investors.
Landfill Economics Lead to Robust Returns
Even as volume loss stunted overall industry revenue growth throughout the latest economic recession, the country's largest landfill owners -- Republic Services, Waste Connections, and Waste Management -- still managed to produce solid cash flows and protect outsize economic returns. This resilience supports our thesis that landfills provide a structural advantage that essentially serves as the anchor for annuity revenue streams -- a competitive edge that prevails throughout the economic cycle. With the exception of Republic Services in 2008 (which acquired competitor Allied Waste), free cash flow as a percentage of sales has been strong and remarkably consistent.
Free cash flow generation is especially important in a highly regulated industry that requires continual reinvestment to remain in compliance, which gives the upper hand to incumbent owners with established operations. Increasingly burdensome environmental regulations have made it expensive to own and operate landfills, requiring large capital outlays to suitably prepare, construct, and monitor sites. Furthermore, permits mandate environmental monitoring for at least 30 years after landfill closure, a significant future financial obligation that must be budgeted well in advance. These factors all serve as considerable barriers to entry, which limits new entrants and causes industry revenue to flow toward incumbent landfill owners.
Additionally, landfill economics create a capital structure that supports the ability to keep a greater percentage of revenue as profit. Although expenses related to site acquisition, cell development and construction, and post-closure obligations are typically quite significant, these are often capitalized and held as assets to be amortized as landfill airspace is consumed. While it is certainly more difficult to sustain high returns on invested capital against such an asset-heavy base, the normal operational costs related to running a landfill, such as scale operations, trash compaction, leachate collection, and methane treatment, are actually negligible in comparison and highly predictable. We believe the operational leverage provided by this capital structure can contribute materially to overall company profitability, which supports even deeper entrenchment of incumbent players as profits are reinvested in the business.
Since new landfill development is constrained by capital requirements as well as political opposition, scarcity of assets in this highly regulated industry further limits competition. These significant barriers to entry provide all three players with the ability to control the waste stream and develop pricing power over time.
Asset Locations Create Physical Barriers to Entry
Running a modern landfill requires such capital commitment that in order to fill capacity and achieve maximum efficiency, the most economically viable sites are near areas that generate ample volume. Since large populations make landfill siting near urban areas attractive, these environments are also among the most competitive. However, the right location can lead to a strategic advantage in these saturated markets, as supply imbalances lead to pricing increases.
According to the Illinois Environmental Protection Agency's latest landfill capacity report, Waste Management runs three of the six active landfills in the Chicago metro region, which includes the city of Chicago as well as eight suburban counties. Much as in other cities across the nation, rapid development in the early 2000s quickly filled area landfills. Of those remaining, Waste Management's properties are some of the closest to the city center. As available landfill capacity gets farther away from this urban environment, local municipalities are faced with the prospect of skyrocketing garbage costs as haulers either have to pay higher tipping fees at remaining active sites or travel much greater distances for disposal options.
Chicago's capacity constraint led to even greater opportunity for Waste Management, as local government in fast-growing suburban Will County needed to develop a comprehensive sanitation plan to handle its burgeoning community. Waste Management leveraged its years of experience controlling Chicago area landfills to win the bid for the development and operation of Will County's new Prairie View landfill, which opened in 2004 on the site of a former U.S. Army arsenal. While Waste Management does not actually own the physical land, it has exclusive operational rights to the site. Establishing a new landfill in an urban area is a rare feat that underscores the advantage of being one of the most experienced operators in the right place at the right time.
Waste Connections' Chiquita Canyon is well positioned to benefit from a similar dynamic as waste disposal options in Los Angeles County shrink as a result of the planned closure of municipally owned Puente Hills in 2013. Pricing in the L.A. market had been curbed for some time as this extremely large, government-run landfill had ample supply that kept tipping fees artificially low. Once the landfill closes, it is expected that L.A. County's displaced trash volume will flow toward the closest remaining assets, which should finally cause area tipping fees to increase in response to the capacity constraint.
Waste Connections has a unique strategy in that it prefers to avoid the ultra-competitive, high-volume urban market in favor of vertically integrating a secondary market or establishing franchise control over an entire urban region. Neither one of these strategies is viable in the well-developed Los Angeles market. However, even though Chiquita Canyon did not fit with its non-urban strategy, the attractive location coupled with the unique set of circumstances in the L.A. market presented a compelling opportunity for Waste Connections to break protocol and acquire an extremely attractive asset.
County hauling is largely split among four companies: Waste Management, Republic Services, and two privately held regional competitors. As Waste Connections doesn't compete for hauling business in the area, the landfill site serves as a neutral dumping ground from a competitive perspective. Waste Management's next closest landfill is in Simi Valley -- 20 miles away in a different county -- and haulers that cross county lines must pay an additional $4 per ton because of local government restrictions. As such, it makes economic sense for Waste Management to tip at Chiquita Canyon rather than its own asset. Since acquiring the landfill from Republic Services in 2009, Waste Connections has tripled its volume, and we expect that its attractive location will drive additional volume through its gates -- at higher prices -- once Puente Hills closes.
Franchise Markets Anchored by Landfills Lock In Outsize Returns
In our opinion, franchise markets -- which grant exclusive control over municipal waste volume -- are one of the most attractive arrangements in the U.S. waste industry. More prevalent in the Western states, both Republic Services and Waste Connections benefit from a high percentage of revenue associated with these lucrative long-term contracts -- about 26% and 50%, respectively. However, gaining exclusive control over an entire municipality's sanitation needs for an extended period necessitates sufficient landfill capacity.
About 20 miles northeast of the Vegas Strip is the Apex landfill, the cornerstone of Republic Services' southern Nevada franchise market. As the owner of the largest active landfill in the nation in terms of acreage and daily tons accepted, Republic is capable of handling nearly all of Las Vegas' nonhazardous solid waste. With a size equivalent to 2,000 football fields, Republic estimates that at current disposal rates, Apex's lifespan is 200-plus years. While its size seems almost excessive when compared with the size of the city (only the 24th largest in the nation), Apex's capacity replaces the need for multiple landfills to serve the area. In other words, Republic enjoys efficient scale; it wouldn't be economically viable for a competitor to invest the capital required to start a new landfill when the incumbent's asset more than adequately fulfills the entire future need of the market. Four separate franchise contracts with the city of Las Vegas, North Las Vegas, Henderson, and Clark County ensure that all municipal waste volume -- which encompasses residential, commercial, casino, and industrial/permanent roll-off waste -- ends up at Apex.
Capital requirements for the site are quite significant. The EPA dictates that water must be used for daily dust control on this desert site, and the rocky terrain makes it difficult to construct cells. At considerable expense, Republic drilled two groundwater wells at Apex in order to eliminate the cost of hauling large quantities of water to the site. In addition, Republic allows Las Vegas Paving to excavate unused acreage for rocky aggregate material to sell to contractors, which reduces the cost of preparing these areas for future cells. Republic's years of capital investment in the site combined with its operational expertise in handling the unique challenges of the local terrain ultimately creates huge switching costs for Las Vegas, which would have to transport its waste great distances or wait for a competitor to develop comparable facilities, should it stop doing business with Republic altogether. In our view, this results in a sustainable symbiotic relationship that protects long-term returns.
Landfill Gas-to-Energy Projects Generate Greater Operational Efficiency
Construction of landfill gas-to-energy projects on existing landfills represents one of the more visible efforts being made to maximize asset value. Incumbent landfill owners with the ability to invest in LFGTE development enjoy operational benefits that can expand operating profits as more of these projects come on line.
In addition to positive "green" PR to offset public perception of the allegedly negative environmental impacts of garbage disposal, LFGTE plants produce operational benefits that we believe are even more valuable than the small amount of revenue being generated by selling methane to electricity distributors. To put things into perspective, it takes a lot of waste volume to produce one 1 megawatt of energy. Landfill owners are required by the EPA to control the emission of methane gas, which is naturally produced as garbage decomposes. Traditional methods include building a pipeline network that collects gas to be burned off by a flare. However, these pipelines can also divert methane to power plants that ultimately convert the gas to usable electricity.
Despite all of the positive rhetoric surrounding the future of waste to energy, LFGTE projects as a source of material revenue growth is structurally constrained by environmental factors and total waste volume. In addition, in exchange for operational permits, LFGTE revenue is often shared with the host municipality. However, we believe the presence of these projects adds to the landfill's already moaty advantages by generating additional operational efficiencies for the site, providing tax relief in some cases, and strengthening ties between landfill operators and their customers by providing additional sources of revenue for cash-strapped municipal budgets.
We Expect Excellent Long-Term Economic Returns
The overall reduction of municipal waste volume since the bursting of the housing bubble has led to investor concern that expensive landfill assets may someday lack utility. However, we continue to believe landfill ownership provides a strong foundation for economic moats in the U.S. waste industry. In our view, Waste Management, Republic Services, and Waste Connections should enjoy excellent long-term economic returns while leveraging the specific competitive advantages provided by physical asset ownership in this industry.
In particular, with the shares of Republic Services currently trading in 4-star territory, we believe there may be an opportunity for investors to purchase shares at a modest discount to our fair value estimate. In our opinion, Republic has yet to realize the full benefit of its newly acquired landfill base because of the lingering effects of the latest recession. Furthermore, we believe the most recent dip in share price probably came about in reaction to lagging performance in 2011, as the company only managed to achieve flat revenue and operating margins amid a challenging operating environment that included higher fuel costs and lower recyclable commodity values. As industry volume normalizes, we're confident that the operational leverage provided by Republic's expanded landfill network will drive margin expansion.