Waste Services: Cash from Trash?

With volumes growing and price hikes sticking, S&P is upbeat about the industry. Its top pick: Republic Services

by Sam Stovall From Standard & Poor's Equity Research

A recent addition to the Industry Momentum List is the Standard & Poor's Environmental & Facilities Services subindustry Index. This index consists of eight companies in the S&P large-, mid- and small-cap indices. During 2005, this subindustry index advanced 4.0%, while the S&P 1500 advanced 3.0%. Year to date through Oct. 13, this subindustry index has risen 22.5%, while the overall market has risen 9.2%.

This subindustry's rolling 12-month relative strength price chart (below) demonstrates this recent outperformance. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 14-year mean relative strength.

Source: Standard & Poor's

Stewart Scharf, who covers this group for S&P, has a positive fundamental outlook on the subindustry index. Scharf thinks solid waste volumes should improve in line with gross domestic product growth, while pricing initiatives remain the primary driver of organic growth. Although fuel prices have been declining, he believes they will remain volatile and that surcharges and hedging programs are likely to continue to be implemented when deemed necessary. Waste haulers are also seeking—and getting— broad-based price hikes in new customer contracts.

GULF REBUILDING BOOST.

Scharf believes major haulers will risk market-share loss in order to boost revenues via price increases in an effort to offset higher fuel costs and improve operating margins. However, he thinks the leading haulers will try to enhance their customer services in an effort to retain market share. In S&P's view, waste management companies will also focus on controlling vehicle maintenance and medical insurance costs, and investing in fleet upgrades and worker safety programs. The analyst is forecasting mid-single-digit organic growth for 2006, with similar growth likely for 2007.

Although overall construction and demolition (C&D) volume may decline as the housing market softens, Scharf figures volume in the hurricane-stricken Gulf region should continue to rise as unstable homes are knocked down and rebuilding efforts progress. S&P still believes that the interruption of regular collection services from displaced residents and businesses will outweigh any major positive effect from more C&D volume.

In Scharf's view, most waste companies will continue to focus on generating cash for debt reduction, share buybacks, dividends, and some "tuck-in" acquisitions and asset swaps. He sees higher internalization rates (percentage of trash disposed of in company-owned landfills) and improved route density (volume collected along a localized route) aiding operating (earnings before interest, taxation, depreciation, and amortization) margins.