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January 2007

Construction spending impacts solid waste companies

The drop in construction spending being felt across the country is not impacting the bottom-line at solid waste companies yet. Will this change in the months ahead?

“We see that the general economy is still relatively strong. In the residential construction market, we are starting to see some decline as all of the government statistics indicate," said Jim O’Connor, chairman and chief executive officer of Republic Services Inc, during a conference call with analysts to discuss third quarter results. "However, we are still seeing a very strong commercial construction market."

Construction spending fell 1 percent in November, according to the United States Commerce Department. The drop was driven by a 1.5 percent fall in private construction and a 1.9 percent drop in private residential construction. However public construction rose 0.8 percent and federal construction increased 11.6 percent during the month.A recycling center in Orange County, California, has not seen a slump in construction waste.

The Commerce Department also reported that new home starts plummeted 14.6 percent in October to the lowest level in 6 years. Housing starts dropped to an annual pace of 1.486 million units compared with 1.74 million in September. Compared to October 2005, housing starts were down 27.4 percent. Permits for future groundbreaking also fell 6.3 percent to 1.535 million units, the lowest rate since December 1997.

These national results, however, are not having much impact on Fort Lauderdale-based Republic, which is the third largest solid waste company in the country.

"Collectively, our industrial collection business, which consists of temporary residential construction, temporary commercial construction and permanent roll off, continued to grow in the third quarter," O'Connor said. "Within the temporary rolloff business, our residential activity is weaker. However, this is being partially offset by increased activity from commercial construction. Pricing for temporary rolloff is stable."

The drop in construction may start to have an impact, however. "Geographically, we expect that where the government reports that housing construction is down, we will experience similar changes in temporary residential construction roll off work. Recently, the northern states and the eastern states seem to be a little bit softer," O'Connor said.

Construction and demolition waste makes up only a small part of collection and disposal volume at major solid waste companies, according to Stewart Scharf, an analyst at Standard & Poor's Corp. in New York. He said that the two largest waste haulers, Houston-based Waste Management Inc. and Phoenix-based Allied Waste Industries Inc., have not seen a major impact from the recent downturn in housing starts.

"Waste Management's C&D volume contributed only two percent to landfills in the third quarter of 2006," Scharf said. He said that comparisons to a year ago are difficult because Hurricane Katrina cleanup boosted C&D volume last year in the third quarter.

"Construction starts on the commercial side remain robust," Scharf said. "Waste Management has seen some softening in the industrial Northeast and Midwest, based on the weaker housing market and economy. But any impact would be insignificant to the company's overall volume." Scharf said a similar story is unfolding at Allied Waste where only about six percent of revenues are tied to residential roll-off volume.

"During the third quarter, Allied Waste experienced a modest slowdown in a few markets, but we don't expect that to have a major impact on its results. The company's third quarter C&D volumes were relatively unchanged from a year ago," Scharf said.

Prices at both Allied Waste and Waste Management are holding up, Scharf said. "Although the residential housing market may continue to soften in 2007, I don't believe a downturn would have a major impact on solid waste haulers' total volume growth."

Bruce Parker, president and chief executive officer of the National Solid Wastes Management Association in Washington D.C., said he has not heard from any of his members about them having suffered because of the decline in construction spending.

"All the big companies are really the barometer for what's going on because they control most of the bids," Parker said. "I have not seen anything so far where there has been a watershed change or major reduction in construction and demolition waste."

Corey Greendale, an analyst with First Analysis Corp. in Chicago, reported a similar story regarding the impact of the drop in construction spending on the solid-waste industry.

"If you look at the companies as a whole it is not really hitting the numbers in any meaningful way," Greendale said. "The big companies in the industry, pretty much across the board, beat expectations in the last quarter. And expectations for future results went up, even after factoring in lower expectations for construction volumes."

While residential construction has been declining, commercial construction has stayed strong and made up a lot of the difference, Greendale said. He said another reason is that pricing across the industry has remained strong. In previous downturns in construction spending, pricing tended to decline at this point in the economic cycle.

"We’re not seeing that this time around. The large public companies have all become more focused on price, margins and return on capital as drivers of the business," Greendale said. He predicted that residential construction would likely to continue to slow while non-residential numbers should somewhat offset residential construction.

Greendale estimated that 10 percent of revenues is a good benchmark to use for the large integrated solid waste companies for C&D activity.

Of that 10 percent, about half is tied to residential construction and the other half is commercial construction.

Volume growth in the third quarter was .6 percent at Allied Waste, compared to 1.8 percent in the second quarter and 1.9 percent in the third quarter of last year, Greendale reported. For Waste Management, volume growth dropped 1.8 percent in the third quarter compared to a drop of 1.1 percent in the second quarter of this year.

"It looks like it is having some impact. But it’s not hitting the bottom line as much as it has in past cycles, because the pricing has been stable compared to past cycles," Greendale said. "In aggregate, bottom line numbers aren’t really suffering."

Leone Young, an analyst at Citigroup Inc. in New York, reported in a research note that the only pocket of weakness cited by the major solid waste companies was residential housing construction. "On the other hand, non-residential construction is consistently cited as an area of strength offsetting the decline in residential," Young said.

"Pricing discipline is holding on the roll-off side, despite some sluggishness. No one was seeing any general economic weakness, although we would note, that is not surprising as the companies are laggards, not preliminary indicators, and we believe the lag is roughly nine months," Young reported in the research note to clients.

"We believe the solid waste industry is particularly attractive in this current market environment, as it is late-cycle and defensive in nature, which makes it less sensitive to small changes in gross domestic product. In addition, the solid-waste companies have strong free cash flow generating characteristics."

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