JANUARY 2008

Detailed analysis needed for solid waste sector

Margins for solid waste companies improved substantially on a year-over-year basis.

A superficial glance at the latest quarterly results from the major solid waste companies may lead investors to believe that profits are deteriorating in the sector.

But to gain a clearer picture of the sector, analysts say a closer review is needed.

“On the surface it is a little bit deceptive, because if you look at the big three companies, each one of those had a factor in the profit drop that wasn’t really related to the ongoing business,” said Corey Greendale, an analyst with First Analysis Corp. in Chicago. He said the majors all had non-recurring issues that impacted net income.

Phoenix-based Allied Waste Industries, the second largest solid waste company, had some losses and some write-downs associated with divestitures, for example.

Allied Waste reported revenue in the third quarter, ending September 30, 2007, totaled $1.56 billion compared to $1.53 billion in the third quarter of 2006. Net income, however, fell to $17.8 million compared to $62.9 million last year. Excluding one-time items, income from continuing operations actually increased to $66.9 million.

“I don’t think anything has radically shifted as much as you would think by looking at the surface numbers, because of those non-recurring things.” Greendale said. “But it is certainly harder in a down economy to improve the profit margins.”

Greendale predicted that fourth quarter results of 2007 would look a lot like third quarter. “I’m not looking for the economy to improve. I’m looking for it to be pretty consistent,” he said. However, going forward, the comparisons year-over-year will start to get easier. “The reported number on volumes may look a little better,” Greendale said.

“I think the companies are doing a pretty good job. If you compare what the results looked like in the past downturn, it is pretty impressive,” Greendale said. “In the last downturn you saw margins declining.” During the downturn in the previous economic cycle, pricing fell by 15 to 20 percent, he said. This time, pricing is improving.

“Most of the major waste companies reported third quarter earnings slightly better than expected,” said Stewart Scharf, a Standard & Poor’s Corp. analyst in New York.

Scharf said that Waste Management Inc.’s earnings, for example, were negatively impacted by some non-recurring items, such as a labor dispute, timing of certain costs and the absence of a tax credit due to higher crude oil prices during the quarter.

Houston-based Waste Management, reported revenues in the third quarter totaled $3.40 billion compared with $3.44 billion during the same quarter in 2006. Net income for the quarter was $278 million compared to $300 million in the comparable quarter the year before. But the company noted a $16 million after-tax decrease related to the cost of a labor disruption in Oakland, California.

Scharf said he expects Waste Management, along with the rest of the major companies in the solid waste sector, to continue to focus on price increases, despite a small drop off in residential and construction and demolition (C&D) volumes.

“We expect solid waste companies to continue the same strategies during 2008. With volume expected to stay soft and GDP (gross domestic product) growth projected at about 2 percent, we don’t see the haulers willing to sacrifice market share in favor of price hikes,” Scharf said. “As the waste industry tends to lag economic cycles by six-to-nine months, we expect this group to continue to focus on generating strong free cash, investing in the business, repurchasing stock and pushing through pricing initiatives.”

Fort Lauderdale, Florida-based Republic Services Inc., the third largest solid-waste company, also reported a drop in net income in the third quarter. Net income totaled $67 million compared to $77.3 million in the same period in 2006. Revenue increased, however, to $806.2 million compared to $787.1 million the previous year.

Will Flower, vice president of communications at Republic Services, said operating margins during the quarter improved by 20 percent, excluding a charge for landfill remediation costs. “This is the first time our margins have been at this level since the fourth quarter of 2000,” Flower said. He said the record margins are attributable to enhanced efficiency of operations, strong commodity sales, and price increases.

Similar financial results were reported across the entire solid waste sector.

Brian Butler, an analyst with Friedman Billings Ramsey & Co. Inc. in Arlington, Virginia, said that gross profit for the seven public solid waste companies that he tracks were 5 percent higher on average in the third quarter than compared to last year.

“We continued to see solid pricing growth with a group average of 4 percent,” Butler said. “While volumes declined 3.7 percent, the profitability of the group continue to improve with the average EBITDA (earnings before interest, taxes, depreciation and amortization) margins of 27.7 percent versus 26.7 percent in the third quarter of 2006.”

Butler said that he expects solid waste pricing to be in the 3 to 4 percent range in the fourth quarter and into 2008, boosting profitability for the entire sector.

“The only visible weakness has been on residential C&D volumes which have been off materially in 2007,” Butler said. “Despite this weakness, pricing and profitability have improved. I do not see a downward trend in solid waste fundamentals, beyond slower C&D volumes, unless pricing discipline at the public companies breaks down.”

Leone Young, an analyst with Citigroup Inc. in New York, wrote in a note to investors that while weak volumes across the sector remain, the major solid-waste companies are staying the course when it comes to pushing through higher prices.

“We believe the bear argument that the industry does not have the fortitude to price in an increasingly negative volume environment is dying,” Young said.

“It was the failure of price discipline in the last down cycle that made the companies appear more cyclical than we believe the business really is.”

Volumes, meanwhile, are stabilizing, Young said. She said that the year-over-year percentage volume declines reported appear to be bottoming out.

“I don’t believe that the third quarter performance was a prognosticator of a downward trend” in the sector, said Bruce Parker, president and chief executive officer of the National Solid Wastes Management Association in Washington D.C.

“Rational pricing by the public companies is holding strong even during this trying economic environment. And even with a less than sterling third quarter, the margins for each company improved substantially on a year-over-year basis.”­