|Shares Out. (in M):||250||P/E||8.9|
|Market Cap (in $M):||443||P/FCF||11.7|
|Net Debt (in $M):||303||EBIT||71||79|
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Long Biffa (BIFF LN): long-term compounder in the UK waste management industry. 70% upside to 12 month price target, potential for 3x return over 5 year horizon in a highly defensive end market.
Business description: Biffa collects waste from businesses and municipalities and then disposes of it. The waste collection industry in the UK, similar to that of the US, is composed of collection companies, transfer stations, landfills, recyclers and incineration plants. Like the big 3 US firms, Biffa has a presence in all aspects of the industry, as the key to maintaining a profitable collections business is also controlling the means of waste disposal. Similarly, the key to maintaining a profitable waste disposal business is ensuring a steady stream of incoming waste volume by controlling a collections business. Collections businesses have high variable costs and relatively low fixed cost, hence the profitability of a collections business is 100% dependent on controlling the dominant variable cost: waste disposal fees. Things like landfill taxes or price spikes in landfill gate fees can ruin the economics of collection very quickly. By contrast waste disposal facilities like landfills, MRF, and EfW have high fixed costs and high incremental margins. The main risk is that incoming waste volumes are lower than planned and hence don’t cover operating costs. As a result, large waste players own both collection and disposal businesses to maximize profit since each side of the business is enhanced by the presence of the other. As waste companies grow sufficiently large in a municipal or regional context, they become better businesses as collections pricing power is enhanced and volatility of waste volumes decreases, enhancing utilization and margins on disposal facilities.
While the synergies between collection and disposal may seem obvious, Biffa presents its financials in 4 different operating segments which obfuscates the synergies between them. Most US waste firms break out revenue by activity, but Biffa presents revenue, operating profit and margins by activity, which has the unfortunate effect of generating analyst fixation on the volatility of individual business lines and overly complicated SOTP discussions. We believe this focus is not particularly helpful in understanding the business for two reasons. In the first place, Biffa’s own internal transfer pricing determines in which segment the operating profit sits. In the second place, the balance of power (profit) between collections and disposal can shift very quickly and while one looks better than the other today, that can change in the future. On first glance most people love the collections segment (I&C) but hate the disposal businesses (RR&T and Energy), although in reality these are just two sides of the same coin. We model the financials according to their segment disclosure like everyone else, but believe the business is best viewed as a whole, similar to the way people think about WCN, RSG and WM in the United States.
Collections business segments:
Disposal business segments:
Uses of capital: one of the most attractive elements of Biffa’s business is that it offers management the opportunity to redeploy free cash flow at high-teens rates of return.
We expect Biffa to reinvest its cash flow after dividends in both I&C acquisitions and the two EfW plants. Overall we see consolidated EBITA growing around 8-10% per year, excluding the 1x step-up in profit when the EfW plants come online. Upside exists in both the RR&T and muni business given that both are operating at trough levels of profitability. UK government policy initiatives to increase recycling activity via taxes on grocery stores and plastic bottle manufacturers could accelerate RR&T profitability. The reinvestment opportunity at Biffa is one of the aspects of the stock that we find most appealing. For most companies in most industries at this point in the economic cycle the incremental investment menu offers lower returns than the core business or previous investments. For Biffa, incremental I&C and EfW investments actually increase the value of the core business via scale. The reinvestment opportunity is why we think the company is/will be attractive to private equity - not only is the stock extremely cheap on the existing business, the company’s acquisition prospects provide an opportunity for incremental growth equity capital to compound at high teens returns.
On NTM numbers (fiscal year ending march 2020) we see the shares as being worth ~300p, approximately 70% higher than today. The implied valuation is 14x P/E, 6.5x EBITDA, 11.5x EBITA, 2.0x book value and 5.0% free cash flow yield. Basically we are arguing that Biffa should have at least a market multiple considering its defensive end market, open-ended growth profile and reinvestment opportunities. We acknowledge that the energy segment today is a 5.0x EBITDA business given the runoff nature of landfill gas profits, but this will change in 3 years once the EfW plants come online. On a 5 year horizon we think Biffa can grow EBITA to 140mm from 80mm today and command a higher multiple due to scale and higher margins -- yielding the potential for a 3-4x return in the equity. We tend to gravitate towards EBITA, as depreciation in the business represents a real cost; maintenance capex tends to equal depreciation.
All of the above begs the question: if this is a growing business in a defensive end market with the opportunity to reinvest capital at high teens rates of returns, why does it trade at a 9x P/E and below the 2016 IPO price? The answer is investor disappointment with the profitability of the municipal waste business, which has been reflected in both the RR&T (recycling volumes are primarily generated via municipal collections) and Muni segments.
Leverage: Biffa currently has 2.0x net debt / EBITDA. Biffa is planning on increasing leverage to 2.5x net debt / EBITDA to simultaneously fund both I&C acquisitions and the investment in EfW. US peers have the exact same leverage levels (2.5x), which is probably why Biffa management imposed the leverage cap at this level. US investors have historically been ok with this leverage, although in UK circles some describe anything above 2.0x as uninvestable. At a minimum, it’s a point of discussion. Leased equipment is capitalized, and the capitalized leases are included in the leverage metrics, so there is no hidden lease leverage here.
Brexit: We do not profess to have any foreknowledge about what the ending of this circus show will look like. Economically, the worst case is a “Hard Brexit” wherein the lack of pre-existing trade deals with third parties plunges the UK into recession upon the UK’s abrupt exit from the EU. Since Biffa is significantly under-indexed to the most economically sensitive parts of waste collection (e.g. the construction and demolition industries), we do not think that their core waste volumes are likely to suffer. On the contrary, Biffa is likely one of the only beneficiaries of Hard Brexit due to the industry dynamics around refuse-derived fuel (RDF) exports. Looking at a map of the UK, one can draw a rough diagonal line from Norwich to Bristol. The area to the southeast (which includes London) has sufficiently low transportation costs to make exporting packaged trash (RDF) to the Netherlands economically viable. The Netherlands has had an excess of incineration capacity for years (though it is tightening now). After the UK government radically hiked landfill taxes, trash exports became one of the lowest cost waste disposal option for parts of the southeast UK. This is the reason why landfills have struggled to command the same scarcity premium in the UK as they have in the US, and why incineration / EfW plants are quite profitable currently in the northern and middle part of the country (including Cheshire and Leicestershire) where RDF exports are less viable due to transportation costs. In the event of Hard Brexit, trash exports will suffer the same issues as any other UK export due to reversion to WTO rules, and suddenly owners of domestic landfill capacity, like Biffa, will find their assets in extremely high demand. Mothballed landfills will reopen and generate enormous profits. At the very least, we can say that no Brexit, Brexit-in-name-only, the current Withdrawal Agreement, Norway+, and a permanent customs union are all fine outcomes for Biffa, and they are probably the only public company that would explicitly benefit from a Hard Brexit.
In conclusion, we believe Biffa is a well-managed company with extremely strong growth prospects and a very cheap valuation. The issues in municipal collections and recycling that vexed the company this year are not structural in nature and offer the company opportunities to further consolidate the industry to its own benefit. If the market doesn’t recognize the ability to compound returns in this stock, it’s likely that private equity will.
Further I&C acquisitions
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