Tuesday, July 18, 2017

Advanced Disposal Services: Hauling a Heavy Load

Shares of regional waste handler Advanced Disposal Services (ADSW:  Nasdaq) have provided shareholders a 29.2% return since the company’s October 2016 initial public offering.  Since ADS does not pay a dividend, the price appreciation is all shareholders get.  Many who took a position in the highly leverage waste business may be surprised at the strong reception.   

ADS is the most recent in a long string of waste management companies to parlay a series of acquisitions into a regional or national business.  Most have had a family business background.  A waste collection business started in the late 1800s by Harm Huizenga served as a backbone for Waste Management (WM:  NYSE) taken public by his grandson Wayne Huizenga in 1971.  Waste Management operates across the entire U.S. and is valued at over $32 billion in market capitalization.  Casella Waste Systems (CWST:  Nasdaq) was founded by John and Douglas Casella as a brothers’ partnership in Rutland, Vermont.  Casella now serves customers in 34 states. 
Advanced Disposal journey to the public capital market was slightly different.  The company was started in 2000 by Charlie Appleby along with business partners Felix Crawford and Walter Hall.  Crawford and Hall each had prior experience in the waste handling industry, but before starting ADS, Appleby was a retired military officer.  The ADS management team is emulating the growth strategies of its competitors, but free of family history and ties to communities, the company had taken the use of leverage to finance acquisitions to a new level.
ADS has completed 45 acquisitions since its highly strategic purchase of Veolia’s ES Solid Waste subsidiary in 2012 for $1.9 billion.  While internally generated cash may have paid for a portion of those deals, management has not been timid about leveraging its balance sheet.  ADS staged its IPO at a time when the company’s balance sheet had $2.3 million in long-term debt.  Granted the company had $1.2 million in cash on its balance sheet as well, leaving $1.1 billion in net debt.  Nonetheless, stockholders’ equity of $466.5 million was overshadowed by liabilities, putting the debt-to-equity ratio near 4.10.  The IPO was completed along with a reorganization of the company’s obligations such that immediately following the transaction debt was reduced to $2.0 million and equity was $791.6 million.  This has brought the debt-to-equity relation back in to line with the industry near 2.50. 
ADS came to the public capital market already hauling a heavy load of debt.  To fulfill its investment case and keep those equity investors who supported the reorganization, ADS must grow fast. 
The industry growth rate is somewhere between 1.6% and 2.0% per year.  Organic growth at that pace may not be enough.  The growth rate must be stepped up with capture of market share.  That might be easier said than done.  ADS has more than just a few competitors in the Southeast, Midwest and Atlantic states where it operates.  It territories overlap with Casella in Pennsylvania and Waste Connections (WCN:  NYSE) in south east states, as well as Waste Management and Covanta Holding (CVA:  NYSE) in all its markets.  There is also an array of local waste handlers who like to nip at the heels of the larger players.
Acquisitions must continue to be a part of the ADS story.  The consolidation strategy worked very well for nearly all of the other major solid waste handlers.  Waste Management staged its IPO in with a story of industry consolidation and leadership.  Acquisitions are still an important contributor to growth.  In fiscal year 2015, Waste Management reported 5.1% top-line growth of which over a third (37% of total growth) was attributed to acquired operations. 
The solid waste management industry has been in a consolidation stage for over four decades.  The top five solid waste managers, which includes ADS, command about 55% of total industry activity.  Yet solid waste remains somewhat fragmented with smaller, locally-owned and privately held operations accounting for just over 20% of the market.  Population growth, improved incomes and urbanization are contributing to the expansion of the industry globally.  IBIS World estimates the U.S. solid waste management industry was approximately $63 billion in 2016, compared to $52 billion just ten years earlier.  The same study forecast growth to continue at a pace of about $1 billion per year over the next three years to $66 billion in 2019.
In the U.S., new entrants are still setting up shop.  The industry platform manta.com lists 1,927 companies under waste disposal in the U.S.  Certainly, there is competition among the top five players to pull these smaller shops into their respective waste networks.  Waste Management overtly displays names and phone numbers of its business development representatives on its website, welcoming solid waste handlers to sell their businesses. 
However, the real competition for ADS may come from changes in solid waste handling and how much disposal should cost.
Indeed, the start-up Rubicon Global has a very different view on solid waste than the top five companies with their large networks of trucks, transit sites and landfills.  Rubicon is bringing a new dimension to solid waste disposal by creating a virtual market place where small, local waste haulers can bid on portions of large national contracts.  Rubicon analyzes the waste streams of large companies and sets up plans to reduce costs, mostly by eliminating unnecessary pick-ups. Rubicon claims it can save as much as 30% from fees charged by the large national waste management companies that own their trucks and landfills.  The company then markets the waste to recyclers, picking up the recycling revenue and avoiding the costs of tipping fees at landfills. 
Rubicon is creating opportunity for small waste handlers and cranking up price competition in waste handling services.  Its customers include 7-Eleven and Wegman’s.  Rubicon claims is has a customer base of over 5,000 businesses that use Rubicon’s app to book trash pickup.  Its story of low-cost disaggregation, environmentally sound disposal and recycling has been well received by customers and local waste handlers alike.
Small as it is Rubicon Global may be a force for the reckoning.  The company has raised a total of $95 million in early stage capital, including $50 million in a recent round in September 2016 that valued the company at $500 million.  Importantly, it is using its own balance sheet and business connections to arrange financial support and equipment supplier relationships for its haulers. 
Advanced Disposal Services did not come to the waste management industry with the same ‘family culture’ and it may not find reception in the market for acquisition targets to be as free-wheeling as in the past.  However, investors have embraced the company despite the risky, debt-laden balance sheet and the presence of significant completion on all fronts.  Traders have driven ADSQ valuation higher over the months since the IPO.  At a forward earnings multiple of 42 times the consensus estimate for the year 2018, the stock does not seem like a bargain. 
Given the business model with significant non-cash expenses like depreciation and amortization, it is probably better for investors to look at EBITDA multiples or sales-to-cash conversion rates.  Unfortunately, current price to EBITDA multiple based on trailing EBITDA is a whopping 88.3 times.  There are no published EBITDA estimates. 
On a more encouraging note, the ADS was able to convert 19.6% of its sales to operating cash flow in the twelve months ending March 2017.  Free cash flow after capital expenditure was $66 million, providing some assurance that the company can whittle down its debt levels. 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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