The Long and Short
Relative value in Waste Connections
Meredith Contente | June 23, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Waste Connections Inc. (WCNCN: Baa1/BBB+/BBB+) appears poised to price much closer to peers after a recent upgrade by Moody’s and after posting best-in-class EBITDA and free cash flow margins. The company’s strategy of focusing on underserved markets and exclusive municipality contracts has delivered strong operating performance while limiting competition. Management has remained disciplined with conservative financial policies and has maintained leverage within their target range. Furthermore, the waste management business has long been considered recession resistant and provides for a relative safe haven in a weaker economy.
Now that WCNCN’s ratings are equalized with RSG and given its stronger margin profile and better leverage metrics, WCNCN should collapse closer to, if not on top of, Republic Services, Inc. (RSG: Baa1/BBB+/BBB+). WCNCN bonds provide for a pick-up of roughly 17 bp g-spread across the curve, relative to RSG. This relationship should flatten as WCNCN is anticipated to maintain its margin prowess, while leverage should decline further on EBITDA growth.
Exhibit 1. WCNCN Curve vs. Peers (RSG and WM)
Industry Leading Margins and Cash Flow
As the third largest solid waste company in North America, WCNCN employs a differentiated strategy which is primarily focused on exclusive and secondary markets. Since the company’s inception, management has maintained a purposeful market selection strategy which has provided for stronger margins and free cash flow generation relative to peers (Exhibit 2). WCNCN’s current mix of business is roughly 40% exclusive/franchise markets and 60% competitive markets. Their exclusive markets tend to be focused on multi-year municipality contracts which provides for good revenue visibility. On the competitive market side, the company remains focused on secondary or rural markets where there is less competition. These markets tend to benefit from greater population growth and lower churn trends. Additionally, WCNCN tends to be the only vertically integrated player in many of these markets which also provides for a competitive advantage.
Exhibit 2. WCNCN Margin and Cash Flow Analysis vs. Peers
Leverage Maintained Within Target Range Despite Increased M&A Activity
Given its strong margin and free cash flow profile, WCNCN has been able to keep leverage within its 2x-3x target range. Given that the waste management industry is mature and competitive, acquisitions are an essential part of the company’s growth strategy. However, the business is highly fragmented, and acquisitions tend to be of tuck-in size. Management has been successful in maintaining operational efficiency while integrating acquisitions, which has been essential in keeping leverage within management’s targeted range.
WCNCN just witnessed a recent period of outsized M&A activity, with the company completing $2.3 billion of solid waste acquisitions in 2022 alone. The acquisitions are expected to add roughly $640 million of annualized revenue. In fact, from 2016-2022, WCNCN noted that of the $17.6 billion of capital deployed, 64% was allocated to M&A activity. In a more normalized capital deployment environment, WCNCN typically allocates approximately 22% to M&A activity. Despite the increased M&A activity, WCNCN ended the year with total leverage of 2.9x. Its leverage ratio compares favorably to both RSG and Waste Management, Inc. (WM: Baa1(p)/A-/BBB+) whose total leverage stands at 3.0x and 3.1x, respectively.
Recent Moody’s Upgrade Equalizes Ratings with RSG
Moody’s upgraded WCNCN to Baa1 with a stable outlook in early June 2023. The upgrade and stable outlook reflect the strength of WCNCN’s operating performance and industry leading margins despite weakening economic conditions. The agency goes on to note that WCNCN’s continued top line and EBITDA growth is anchored in its solid pricing fundamentals and strong cost discipline. Furthermore, the non-discretionary nature of the waste management sector provides for continued profit generation despite economic downturns.
Moody’s believes that WCNCN can continue to generate at least $900mm of free cash flow annually (after dividends) which supports its acquisition strategy. M&A activity this year is expected to moderate relative to 2022. WCNCN has not completed or announced any acquisitions year-to-date.
While WCNCN’s revenue base is smaller than its peers, its strong credit metrics and EBITDA margins temper any scale concerns, according to Moody’s. Furthermore, leverage is expected to close the year closer to the 2.6x.-2.7x area, based on management’s full year EBITDA guidance of $2.5 billion, which was just reiterated on the most recent earnings call. Management noted that there is upside to current annual guidance as inflation begins to moderate and recovered commodity values improve.
Sustainability-Linked Investments Remains a Focus
WCNCN has already achieved a net carbon benefit beyond Net Zero as operational offsets now exceed emissions by 3.4x. Management noted that it has also achieved absolute reduction in emissions as well as a two-year reduction in emissions intensity of 18%. WCNCN is also focused on a growing pipeline of renewable natural gas (RNG) projects. The company’s $200 million investment in RSG facilities is expected to produce at least $200 million in annual EBITDA by 2026.
Over the next 2-4 years, WCNCN will have roughly 12 RNG projects in development at landfills. Longer term, that number will increase to the 15-20 range. Projects will include a combination of new facilities coupled with the conversion of electrical generating facilities. These new facilities are consistent with WCNCN’s long-term ESG targets which include a 15% reduction in Scope 1 and 2 emissions as well as an increase of 40% of biogas recovery.
Additionally, WCNCN has two recycling facilities under construction, which are expected to come online by 2024. The new facilities will employ enhanced optical sorters as well as robotics, which are aimed at improving output quality while producing labor savings. The new facilities also align with its longer term ESG target of increasing resources recovered by 50%. Furthermore, the use of robotics and new sorters should help bring the company closer to its target of reducing facility incident rates by 25%.