CA - Waste Connections: Landfill Issues In California And Texas Are Temporary Buy The Weakness Now

2023-11-02 02:57:42 ET

Summary

• Waste Connections reported landfill issues in California and Texas, resulting in additional operating expenses in Q4.
• The California landfill issue is expected to take a relatively long time to resolve and may result in penalties.
• Despite the landfill issues, Waste Connections achieved strong core price growth and a solid financial performance in Q3.

Waste Connections ( WCN ) reported their Q3 FY23 results on October 25th. They disclosed landfill issues in California and Texas, which are expected to result in additional operating expenses in Q4. These issues were not anticipated in the guidance provided in August 2023. I believe these landfill problems are temporary and one-time in nature. I encourage investors to consider buying during this period of weakness and maintain a 'Buy' rating.

Landfill Issues in California and Texas

In the Q3 FY23 earnings call , Waste Connections' management disclosed landfill issues in California and Texas. They incurred an additional $6 million in operating expenses this quarter for their Chiquita Canyon Landfill in Southern California, where the landfills are facing elevated temperature or ETLF events. They do not expect the issue in California to be resolved in the next quarter; however, they believe it is a non-recurring event. The management indicated that in 26 years, none of their more than 100 landfills had experienced these elevated temperature issues, despite occasional industry occurrences.

On page 129 of the County of Los Angeles Report , it shows that on October 16th, Chiquita Canyon Landfill experienced a smoldering event deep beneath the landfill, driving up temperatures as high as 201 degrees Fahrenheit. This event caused increases in odors, carbon monoxide gas, and gas pressure, damaging the system of wells used to extract hazardous gases and prevent their release.

According to the United States Environmental Protection Agency , elevated temperature landfills ( ETLFs ) have occurred several times in various landfills, including Bridgeton, Countywide, Waimanalo Gulch, and others. The final migration strategy varies, including the installation of gap collection systems, excavation of a portion of the landfill to physically separate impacted and non-impacted areas, installation of geomembrane caps, and other solutions. I believe Waste Connections can eventually resolve the issue in California, although it will incur additional operating expenses and potential penalties in the near future.

Using Republic Services' ( RSG ) Countywide landfill as a reference, they began experiencing ETLF issues in 2006, caused by aluminum dross disposal and leachate recirculation over the co-disposal area. According to media reports , the Ohio Environmental Protection Agency finalized a $10 million settlement with Republic Services regarding its landfill in Pike Township, the Countywide Recycling & Disposal Facility, in 2009.

Additionally, the Texas landfill issue involves a slope failure, acknowledged by Waste Connections as a mistake made by their own staff. They admitted that their own people were responsible and that it could have been prevented. The landfill had to be closed for repairs and sitework. They expect the issue to be resolved in the next quarter. In my opinion, the Texas landfill slope failure is a one-time issue that can be resolved quickly; however, it will incur additional expenses in Q4.

Overall, I believe the California landfill issue might take a relatively long time to be resolved, and they might face penalties for that incident as well. Both issues, in my view, are temporary and one-time in nature.

Quarterly Financial and Outlook

In Q3 FY23 , Waste Connections achieved a 6.4% internal revenue growth, driven by an 8.8% core price growth, despite a decline of 2.4% in volume. As outlined in my introductory article , Waste Connections has been actively engaged in a contract review initiative for their acquired businesses. By strategically walking away from low-margin contracts, they have effectively bolstered core price growth while experiencing a reduction in overall volume. The recent quarterly results validate the success of this initiative, showcasing robust core price growth.

In terms of margins, Waste Connections saw a 120 basis points increase in adjusted EBITDA margin compared to the previous year and a sequential rise of 140 basis points from Q2. However, challenges arose in their California landfill, where they anticipate additional expenses exceeding $10 million in Q4, primarily due to increased leachate generation. Management clarified they cannot currently estimate the ultimate impact, timing, or solutions for this issue. They expect to gain clarity on these aspects by their February 2024 call.

Regarding the Texas landfill, an additional $5-10 million in costs is anticipated for Q4, with plans to reopen the landfill in mid-December. Despite these challenges, the underlying growth for the quarter remains robust and solid, albeit overshadowed by the landfill issues.

Year-to-date, Waste Connections generated $969 million in free cash flow, equating to a 16.2% cash flow margin. They project $1.225 billion of free cash flow for the full year, excluding ongoing landfill impacts, estimating these impacts to be around $20 million for FY23.

On the balance sheet front, debt leverage remained unchanged this quarter at 2.75x. The average cost of debt stands at approximately 4%, with an 80% fixed and 20% variable mix, indicating a strong and resilient balance sheet.

Looking ahead to Q4, Waste Connections anticipates revenue of $2.04 billion and an adjusted EBITDA of $658 million, accounting for 32.3% of revenue. Considering their historical performance and ongoing contract review initiatives, the Q3 results and Q4 outlook appear relatively normal. The disappointment for Q3 stems mainly from the challenges faced in the two landfill issues.

Valuation Update

There has been no revision in the revenue aspect of the Discounted Cash Flow model, despite my altered expectations for their revenue growth due to the two landfill issues. These problems will inevitably lead to additional operating costs for the company. I anticipate an extra $20 million in costs for FY23, as indicated by the management. Furthermore, given the prolonged resolution timeframe for the California landfill issue, I have factored in an additional $20 million in operating costs for FY24, along with $10 million for legal penalties in the same year.

Apart from these supplementary costs, I have kept all other assumptions unchanged. The recalculated fair value of their share price amounts to $142. I believe the market has overreacted to the landfill issues.

Conclusions

I am impressed by their core price growth driven by contact review initiatives, and I think the California and Texas landfill issues are temporary and non-recurring. I maintain “Buy” rating with $ 142 per share fair value and encourage investors to buy the dip.

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