Description

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.  

• Similar to the US in the early 1990s, the UK waste collection and disposal market is highly fragmented, with the largest player (Biffa) having only a 10% national market share. Biffa is following the Republic Services playbook of tuck-in acquisitions to increase collection route density and utilization of waste disposal facilities (landfills, material recovery facilities / MRF and energy-from-waste / EfW power plants).
• As Biffa increases scale it becomes a better and better business, generating higher operating margins and low cash flow volatility due to diversification and network effects.
• Despite an open-ended runway for growth, Biffa trades at less than half the valuation of US peers. On NTM figures Biffa trades at 5.0x EBITDA, 9.0x P/E and 8.5% FCF yield to equity.
• The people who the know the most are buying:
  • the CFO purchased 150,000 shares at 193p on 12/4/18, with smaller additional purchases in January.
  • Avenue Capital (Marc Lasry’s firm) increased its stake from 16.0% to 18.0% on 1/18/19 at 188p. 
• The company is a no-brainer target for private equity. Biffa has an extensive opportunity set for reinvesting capital at high returns (tuck-in acquisitions, EfW) but is currently gated by the pace of its organic cash flow generation and self-imposed leverage limits (2.5x Debt/EBITDA). The business is a great place for financial sponsors to invest growth capital at (likely) higher leverage levels.

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:

• Industrial & Commercial: Picking up waste from small and medium sized businesses is the bread and butter of the industry. Volumes grow at real GDP (e.g. 1%-1.5%) with 2.5-3.0% price inflation = 3.5-4.5% organic revenue growth. As garbage pickup is an extremely small part of most businesses’ cost structure, customers tend to be quite sticky unless there is a service problem. 60% of revenues come from SMEs, 40% from corporates. Biffa’s collection volumes are relatively acyclical as they have limited exposure to the construction end market (e.g. homebuilding and nonresidential construction). The corporate market is increasingly moving towards segregated collections, which greatly benefits Biffa’s market share and win rate in the corporate sector as the industry’s largest player. Smaller competitors simply do not have separate trucks for collecting glass, cardboard, metals, food, etc as a function of scale.
• Municipal: Of the 400 waste collection authorities in the UK, around 40% outsource their services. Biffa services 40 of those (25% market share) on multi-year contracts and generates revenue from collections (70% of segment revenue), street cleaning (20%) and ancillary services (10%). Given the size and multi-year nature of each individual muni contract, competition from small local players tends to be the most intense in this segment, resulting in lower margins. A mom-and-pop player can “live” out of a single contract and hence will bid very aggressively. Biffa is not growing in this segment and basically uses the volume generated to keep its disposal facilities in a given area full. As industry consolidation progresses, bidding in this segment will likely become more rational, as it has in every other jurisdiction with consolidated market share among waste contractors. To that point, Biffa management believes that margins have bottomed out in this segment in the last 6 months.

Disposal business segments: 

• RR&T (Resource Recovery & Treatment): This segment includes landfills, hazardous waste disposal facilities, MRFs (recycling facilities), and soil treatment and composting -- essentially businesses where the collections companies send their waste. This segment is also the one most subject to government policy changes. Ten years ago the UK government massively increased landfill taxes, which made ownership of existing landfills a condition to surviving in the collection business as landfills simply passed on the tax via gate fees. Currently the UK government is actively working on policy to increase recycling activity, which will increase the profitability of MRFs via increased volumes. (https://www.theguardian.com/environment/2018/nov/11/retailers-to-pay-up-to-1bn-more-for-recycling-under-waste-strategy)
• Energy: This segment currently includes landfill gas (85% of segment EBITA), the West Sussex mechanical and biological treatment plant (15% of EBITA), and two EfW power plants about to start construction. The landfill gas component is a ‘wasting asset,’ while the MBT generates stable profits. As such, segment profit should decline by ~7% per year until the EfW plants come online, which will generate 10-12mm in operating profit in 2022.

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.

• I&C acquisitions: Biffa has been purchasing small collections businesses at prices of 7x trailing EBITDA, 3.5x-5.0x post synergies. Basically Biffa buys a portfolio of local small business waste collection contracts in a given city, integrates the contracts into their existing route planning over a weekend, and shuts down the back office of the acquired business.The incremental EBITA margins on these deals is around ~18%, compared to the current segment margins of 8-9%. Biffa expects to generate around 4% organic growth in I&C collections, and 3-4% acquired revenue growth annually for low double digit segment EBITA growth
• EfW plants: EfW plants in the UK are high margin, local monopoly disposal assets due to government tax policy favoring incineration over landfilling. These sites can take over a decade to receive planning permission due to NIMBY politics. Biffa has partnered with Covanta to build two new EfW plants in Cheshire and Leicestershire, with Biffa owning 50% of the equity in return for delivering waste volumes to the plants. 70-80% of EfW economics are gate fees charged to waste collection companies with electricity generation comprising the remainder. Biffa expects a high teens return on equity on their investment, and well-located plants receive utility-like valuations in the private market (high teens EBIT multiples).

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. 

• Mixed paper and RR&T:  investors were first upset with Biffa in March 2018, when it guided that fiscal 2019 EBITA would be flat to slightly up (rather than +8-10%) as a result of China’s policy of banning mixed paper imports. The Chinese government in 2017 banned the import of recovered mixed paper with greater than 0.50% impurities as part of their National Sword environmental campaign. Recovered paper is one of the recycled commodities that RR&T sells, representing £12mm per year in revenue. The commodity is an important input for manufacturing paperboard, much of which is made in China and used in packaging applications globally. As Chinese customs officials were not able to visually verify whether or not a given ton of recovered paper had the required 0.50% purity standard, they essentially halted all imports into the country by early 2018. Since China was importing 50% of all recovered paper globally, this change caused the price of mixed paper to drop to £0 or negative ex-China, while it skyrocketed within China itself as mills had to use virgin pulp to offset their lack of recycled feedstock. Biffa previously received £70/ton for recycling mixed paper, and they assumed in their profit outlook in March that mixed paper would trade at £0 in perpetuity. As it turned out in the subsequent nine months, mixed paper pricing rebounded to £30/ton, since supplies were simply rerouted to paperboard manufacturers in Southeast Asia and Chinese paperboard manufacturers purchased mills outside of China that could source mixed paper raw materials. Longer term we do not think this is an issue for Biffa, as the entire industry is repricing contracts with municipalities to have the commodity price fluctuations borne by the municipality rather than the recycler (currently Biffa’s contracts are a 50/50 sharing of price fluctuations). MRFs are currently running at breakeven for Biffa and generating losses for smaller players. Hence it is likely that the whole industry migrates to some form of cost plus regarding recycling collections, or else smaller players in municipal recycling are likely to simply exit the business.
• Muni collections profitability: in November 2018 Biffa disclosed that the operating margin of its municipal collections segment was 2.5% for the half year as opposed to historical levels of 5-6%, and guided to this margin continuing in perpetuity. While the disclosure was a surprise to investors, the deterioration in front-book (new bidding) contract margins had been ongoing for some years as smaller collections players had been increasingly aggressive on bidding for new business. In the half year, a number of legacy higher margin contracts rolled off and the segment reported financials resembled the newer vintage contract margins for the first time. As management did with the recovered paper issue discussed above, they guided for low profit margins in the muni collections segment to continue in perpetuity, causing a number of investors to give up on the company. While management thought they were being conservative on guidance, many investors concluded that they were foolish for being in the muni business in the first place.
• The reality is that, with municipal collections close to break-even profitability for the country’s largest waste collector and municipal disposal/recycling operations generating losses, many smaller waste companies are facing financial issues. The pain being felt at smaller players is causing municipal collection contracts to be repriced such that the local authorities are bearing the swings in recycled commodities going forward (rather than the waste collectors). Furthermore, the disruption is giving Biffa the chance to further consolidate the industry as mom-and-pop players struggle to make money and look to exit. The industry’s current troubles are sowing the seeds for a better industry structure in the future. On the whole we don’t think putting a trough multiple on trough muni/recycling profits is the right way to value the stock. In any event the company’s resilience is such that March 2019 fiscal year numbers incorporate two of Biffa’s segments operating at marginal profitability and the company still seems likely to post a small year-on-year increase in operating profits. Recycling is the centerpiece of UK government waste policy, and it’s likely that the industry will rebound over the next few years to the benefit of the scale players who are making the investments in processing capacity today.

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. 

Catalyst

Further I&C acquisitions