Description

I am recommending the purchase of Waste Industries USA, Inc. (WWIN) common stock based on a compelling risk/reward proposition with very low downside and substantial upside relative to very modest risk and volatility. Like my previous recommendation of InfoUSA in April, I like situations where a company’s level of cash flow generation and its valuation relative to public comps and on a private market basis is such that there is a reasonable floor on valuation near the current stock price and meaningful upside.

WWIN is a regional, vertically integrated solid waste services company providing solid waste collection, transfer, disposal and recycling services to commercial, industrial and residential customer locations in the Southeastern U.S. The Company operates approximately 40 collection operations, 26 transfer stations, 8 recycling facilities and 11 landfills. The Company’s website (www.waste-ind.com) has all of its public filings, and WWIN is covered by Lehman Brothers, Deutsche Bank and Friedman Billings Ramsey for additional perspective so I will not go into any detail on the description of the business, which is pretty straightforward anyway. Like all businesses of any scale in the garbage industry (the big 3 are Waste Management, Allied Waste Industries and Republic Services), WWIN was built by acquisition since 1990, though the level of acquisition activity has trailed off significantly in recent years.

Set forth below are some summary financial stats on the business; all figures except per share data are in millions, exclude nonrecurring/extraordinary items and represent an estimate for calendar 2003:

Revenues $267
EBITDA 57
Net Inc 10.8
EPS 0.80
FCF 13.1

FD Shares 13.5
Price (12/5) 9.26
Market Cap 125
Net Debt 154
EV 279

EV/EBITDA 4.9x
P/E 11.6x
FCF Yield 10.5%

Garbage is not a sexy business, but it is a profitable one: the public waste companies have EBITDA margins ranging from 21% to 34% and EBIT margins in the high teens to mid 20% range. (I focus on EBITDA because that is how the public and private markets tend to value these companies.) The reason for the wide disparity in industry margins relates to mix of business because disposal (operating landfills) is the highest margin business (40-70% EBITDA margins) but is somewhat capital intensive while the collection business has lower margins but does not require much capital. WWIN’s EBITDA margins are at the low end of this range because it has a higher mix of collection than disposal, in part because the markets in which it operates historically have enjoyed ample supply of landfill space. The mix of landfills in the business has a further impact on margins due to the economics of what the industry calls internalization, which means the amount of garbage you collect that goes to your own landfill. This is an important industry metric because the incremental margins of additional volumes brought to an owned landfill can be 75-90%. At the high end, Allied Waste has 70% internalization while WWIN is at the low end of the industry at 27%.

At 4.9x EV/EBITDA, WWIN is trading at a substantial discount to its peers and to its private market value. Waste Management and Republic trade at 8-9x EBITDA while Allied Waste trades about a multiple lower due to its riskier financial profile (4.8x Debt/EBITDA). Among the smaller/regional players, Waste Connections, a well-run consolidator, trades at over 8x while Casella Waste, a regional player that is probably WWIN’s best comp, trades at 7.5x. On a private market basis, WWIN would fetch at least 6.5-7x EBITDA in an LBO and could command up to 7.5x or more from a strategic acquirer. At 6.5-7.5x EBITDA, WWIN is a $16-20 stock.

The primary reason for WWIN’s substantial discount is its low float and effective control by the founding Poole family, who own approximately 40% of the Company. The CEO, who has been with the Pooles since the beginning, owns an additional 12%. As a result, the Company’s average daily trading volume is 7,000-9,000 shares, which effectively precludes many institutional investors from getting involved.

The primary catalyst for the shares will be an increase in the float (i.e. if the Pooles sell some shares) or an outright sale of the Company. The founding Poole is 65 and relinquished the CEO position in 2002. The Company recently instituted an $0.08 semiannual dividend (1.7% yield), which surprised many analysts given alternative uses for the capital (acquisitions, debt reduction) and was construed as an attempt to increase liquidity for the Poole family. It is well known in the industry that every major player has approached WWIN, but the issue with a sale historically has been the Poole family’s unwillingness to relinquish control, an issue that may dissipate given the founder’s withdrawal from daily operations and his advancing age. WWIN’s operations would be a great fit for any of the big 3, who all have major landfills in the region and could extract substantial synergies and internalization benefits.

Even absent an outright sale of the Company or a secondary offering of shares that improves liquidity and technical trading dynamics, WWIN should trade up as its earnings improve. Although much of the garbage business is not cyclical (e.g. residential), the commercial and industrial business does have some modest cyclicality, and volumes should improve as the economy picks up steam. The economics of the trash business are such that incremental volumes typically carry high marginal contribution rates. Moreover, WWIN operates in one of the best regional markets in the country, with better than average household and business formation (compare Casella Waste, which operates in the slower growth New England states). Indeed, the Company’s third quarter provided some evidence of a nascent pickup in business as WWIN grew revenues organically at 4%, 2.4% of which was volume. FBR estimates that WWIN will grow EBITDA 10% in 2004 and EPS by 18% so even without an event to drive substantial price appreciation, WWIN should trade up in line with the improvement in cash flow and earnings, even with no narrowing of the significant discount at which it trades. Finally, the market rewards accretive acquisitions in this industry (e.g. Waste Connections), and WWIN could drive substantial value creation and spark a rally in its shares with additional accretive acquisitions, particularly of landfills at which it can internalize waste.

Catalyst

Sale of the Company
Secondary share offering that improves liquidity
Cash flow and earnings growth