CA - Waste Connections: Concerns Despite A Great Track Record

2024-01-02 16:13:18 ET

Summary

• Waste Connections, Inc. has been a strong long-term value creator, with shares trading at fresh highs.
• The company has experienced significant growth through acquisitions and has seen strong financial performance.
• However, there are concerns about the company's valuation and potential challenges with landfills in California and Texas.

Waste Connections, Inc. ( WCN ) has proven to be a really strong long-term value creator, with its shares trading at fresh all-time highs as the company enters 2024. My last take on the business dates back to 2016, when a great business announced a nice acquisition, but looked a bit rich to me.

Little could I have imagined that WCN shares would quadruple in the eight years which followed, demonstrating great performance. While I have great respect for this, I fear the risk-reward here amidst high valuations and the composition of organic growth.

A Recap

Waste Connections was doubling the size of its business back in 2016 with the purchase of Progressive Waste Solutions, a large deal which was the latest in a string of successful smaller acquisitions, in which premium stock was used as expensive currency to transact. Stable cash flows, low interest rates, and optimism of investors resulted in high valuations at large, fueling this growth.

Waste Connections acquired Progressive Waste in an all-cash transaction valued at $2.5 billion, although the deal tag increased to $3.9 billion if we factor in net debt of Progressive. This valued the business at nearly 2 times sales of nearly $2 billion and an 8–9 times EBITDA multiple, albeit that the depreciation and amortization component was rather steep.

Waste Connection itself was valued at nearly $9 billion at the time (on an enterprise basis), with shares trading at $55 per share, with its business trading around 4 times sales. This higher sales multiple versus Progressive was driven by the superior margins reported by Waste.

Pro forma sales were seen around $4 billion, with EBITDA seen close to $1.3 billion. Net debt of $3.4 billion resulted in a higher, but manageable, leverage ratio of 2.7 times. The 174 million pro forma share count valued equity at $9.6 billion, valuing the entire business at $13 billion, equal to 10 times EBITDA, as this metric of course differs from free cash flows.

Despite the high valuations, with pro forma earnings power seen below $2 per share, Waste Connections has been a very successful stock, with shares having increased by ten-fold from about $5 at the time of its IPO in 1998.

On Fire

Fast forwarding eight years in time, we see shares of Waste Connection traded around the $150 mark, which suggests that shares have tripled, but as shares have actually seen a 3-for-2 stock split in 2017, share in fact have more than quadrupled over this period of time.

Forwarding to February 2023, Waste Connection posted its 2022 results, which revealed that revenues had grown from about $4 billion on a pro forma basis in 2016 to $7.2 billion. Adjusted EBITDA margins in the low thirties were very strong, equal to about $2.2 billion, with adjusted earnings up 18% to $985 million, equal to $3.82 per share. Such kind of earnings power was perfectly capable of supporting a roughly $5.0 billion net debt position.

With a share count of 258 million shares, a $135 million stock at the time supported an equity value of about $35 billion, or $40 billion if we factor in net debt. This valuation was full at nearly 6 times sales and about 18 times EBITDA, all pretty demanding multiples, with shares trading at around 35 times adjusted earnings.

The company provided a solid guidance for 2023, seeing EBITDA advance to about $2.5 billion on a roughly $8 billion revenue base. The strong growth, in 2022 and the years before, made that it became the third-largest solid waste company in North America, focusing on exclusive and secondary markets, driven by an acquisition strategy.

2023 - Solid So Far

The company has seen a solid operating performance so far in 2023. This supported the company into hiking the quarterly dividend by nearly 12% in October, with the quarterly payout of $0.285 per share, representing an annual payout of $1.14 per share, adding to a rapidly growing and impressive track record since 2010.

Later that month, Waste Connections reported a near 10% increase in third quarter sales, with year to date revenues reported up 12% to just shy of $6.0 billion. Adjusted earnings have risen some 5% to $795 million, equal to $3.08 per share, making a run rate in excess of $4 per share look realistic.

Net debt has risen to $6.8 billion here, with EBITDA coming in near $2.5 billion per annum here, for a 2.7 times leverage ratio. Fortunately, net interest expenses, which trend around $200 million, are relatively modest in relation to the debt load.

A Big Deal

By mid-December, Waste Connection's Canadian subsidiary acquired 30 energy waste treatment and disposal facilities in Canada from Secure Energy Services in a CAD $1.07 billion deal, equal to about $800 million US dollars. Combined annual revenues are seen at CAD $300 million, suggesting that a 3.5 times sales multiple has been paid.

With a pro forma revenue contribution of nearly 3%, the contribution is relatively important for the Canadian activities, which make up less than ten percent of Waste Connection's revenues here. Moreover, the deal is set to be accretive EBITDA margins, which reveals superior profitability, as cash flow and earnings per share accretion is expected as well.

Needless to say, expectations of Waste Connections itself have gotten carried away a bit. The 258 million shares of the company granted equity of Waste Connection a $39 billion valuation at $150, as net debt of $6.8 billion has boosted the enterprise valuation to nearly $46 billion. This values the business at around 5.7 times sales, which make the deal look relatively compelling.

Pro forma net debt of $7.5 billion makes that leverage ratio will remain below 3 times, with the pro forma revenue contribution seen at just below 3% at a rather compelling sales multiple (given the superior margins).

And Now?

With pro forma earnings seen topping the $4 earnings per share number, Waste Connection still trades at a huge multiple in the mid-thirties. Moreover, the composition of growth is not impressive, with pricing outpacing inflation for years in a row, and with volume declines posted as well.

More so, the company has some specific issues with landfills in California and Texas which have become too warm and have created too much odor for nearby residents, resulting in potentially hundreds of millions of dollars to be invested in the coming years to control.

Amidst all this, it is very hard to get rally upbeat on the shares in the near term, as expectations are elevated. While I understand why investors like waste businesses, given the predictable and stable cash flows, I have some concerns. Paying a great premium for a business which sees volume declines seems hard to justify, despite Waste Connections, Inc.'s impeccable track record.

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