AR July 2006 -

Higher costs are squeezing profit margins at solid waste companies.

“Everything is going up across the board,” said Worthing Jackman, chief financial officer of Waste Connections Inc. “There are a lot of cost pressures in the system.”

The high price of fuel is not the biggest cost at the Folsom, California-based company, but it is the cost that has spiked the most, Jackman said. Waste Connections had a hedge in place for fuel last year when it paid about $1.35 a gallon. “Year over year it’s almost doubled, given where prices for fuel are currently,” Jackman said.

“Everyone is being hit by these cost increases. These are real dollar cost increases that as soon as a truck fills up at the pump the cash goes out the door.”

Waste Connections uses about 18.5 billion gallons of fuel a year. A $.50 change in the company’s fuel consumption hits the bottom line by $9 million, Jackman said. Fuel prices totaled about 4 percent of revenue last year. Jackman said he expects fuel prices to be about 6 percent this year, assuming fuel is about $2.55 a gallon.

On the capital side of the business, costs have also increased for trucks and containers. It is not just because of higher steel and other commodity prices. Jackman said new emission standards would increase truck pricing from 5 to 7 percent.

Waste Connections is watching expenses closely. “There are always things we’re doing. I’ll say it’s not about cost cutting. We already run a pretty lean organization,” Jackman said. To help reduce costs, for example, Waste Connections has opened three new landfills over the past year. “That’s improving our disposal position,” Jackman said.

“The good news is that higher costs are impacting everyone and you are seeing a general push to raise pricing to cover those costs. What it means for margins is that it takes more revenue dollars to cover the higher costs.” Average price increases across the waste industry have been between 4.5 to 5.5 percent this year, Jackman said.

Waste Connections expected price increases to be between 4 and 4.5 percent during the first quarter. It reported price increases of 4.8 percent. “We came out of the block above the high end of what we guided for the year,” Jackman said.

Higher costs are also impacting Ft. Lauderdale, Florida-based Republic Services Inc. Told Holmes, chief financial officer of the solid waste company, said fuel costs used to be about 3.5 percent of revenue at Republic Service. “Now it’s up around 5 percent, or over 5 percent of our revenue. Fuel is a substantial increase in cost.” Holmes said.

The cost of building landfills is also up. The feedstock for the synthetic liners, used to form the base of the landfills, comes from natural gas. “Those prices have gone up 25 to 35 percent,” Holmes said. Cost of equipment has also increased. “There is a number of areas were the costs have gone up,” Holmes said.

“While we continue to focus on productivity, it only goes so far,” Holmes said. “Therefore we have to go back to the market and say this is the cost of the services.”

Operating expenses at Houston-based Waste Management Inc. increased $56 million in the first quarter compared to last year, said Liz Johnson, a spokeswoman. As a percent of revenue, however, operating expenses declined from 67.3 percent to 65 percent. Higher subcontractor costs factored into the higher expenses in the quarter.

“The two largest causes of this increase were higher indirect fuel costs passed on to us by third-party haulers and costs related to work in New Orleans where we used subcontractors in connection with the Hurricane Katrina relief effort,” Johnson said.

Waste companies are implementing a number of cost-cutting measures, said Stewart Scharf, an equity analyst for Standard & Poor’s in New York. “Most of the major haulers are seeking across-the-board price hikes to drive top-line growth and offset rising fuel costs. Fuel charges and hedging programs are also being implemented,” Scharf said.

Other initiatives include the upgrading of aging truck fleets. This reduces repair and maintenance costs, Scharf said. It also improves fuel efficiencies. Waste companies are also focusing on safety programs to reduce the number of injuries, thus lowering the number of employee absentee days, and controlling healthcare costs, Scharf said.

“Solid waste companies are also divesting non-core and under performing assets, and seeking more asset swaps to improve their collection routes,” Scharf said.

“Furthermore, haulers are de-centralizing more of their operations, which places more responsibility at the regional level and lowers costs at group and corporate offices.”

Waste companies reported price and volume growth in the first quarter, said Leone Young, an equity analyst at Citigroup in New York. “Pricing continued to translate into margin expansion, and positively, volumes remained strong, which was in part due to the milder winter and an overall stronger economy,” Young said in a research report.

“Price growth was strong at all companies, pointing to a stronger economy and more rational environment. The companies are now putting more focus on landfill pricing, in order to offset higher landfill development costs,” Young said.

The gross margin at Waste Management, on a year over year basis, was 35 percent, with improvement in every cost category except for fuel and subcontractor costs, Young said. The gross margin at Republic Service was 38.1 percent due to improved pricing and a focus on productivity improvements. At Waste Connections, the gross margin was 40.6 percent due to fuel hedges rolling off in 2006, Young said.

“Each and every price data point remains positive. As a result, we see a margin turn in the industry emerging in 2006. We believe the bear argument that the industry cannot price for its cost inflation is largely dead.” Young said.