Description

I am recommending a long in Allied Waste Industries (AW), which currently is preparing to close by year-end a merger agreement with Republic Industries (RSG).  Waste Management (WMI) has tried to scuttle the deal, which would create a real credible industry #2 behind WMI, by making a hostile offer for RSG, most recently at $37/share.  RSG and its largest shareholder (Bill Gates’ investment vehicle owns nearly 20%of RSG) are adamantly opposed to the WMI offer, which the credit markets has likely rendered moot in any event.  However, I like AW almost regardless of the outcome of the above but particularly if the RSG deal closes as expected.

AW has been undergoing a multi-year turnaround and essentially implementing the same strategy successfully employed by WMI, which entails a focus on operational excellence, pricing, ROIC and returning capital to shareholders.  Despite a difficult economic backdrop, with industry volumes down, the large waste players have been exceptionally disciplined in driving price.  We believe the industry backdrop is as good as it has ever been in what is a somewhat defensive space and that AW’s turnaround is being overlooked, making the stock a very attractive risk/reward proposition at roughly $10/share.

AW is the second largest non-hazardous solid waste company in the U.S., with vertically integrated operations comprising collection, transfer stations, recycling, and landfills across 38 states.  With more than $6 billion in annual revenues, AW is a distant industry #2 to WMI, which has revenues of $13+ billion.  RSG is actually roughly half the size of AW based on revenues, but it is considerably less leveraged and historically has enjoyed a higher multiple than AW given its footprint in the relatively more attractive Sunbelt states and its well regarded management team.  The RSG/AW merger calls for AW shareholders to receive ~52% of the combined company, which will be run by RSG’s longtime CEO and AW’s COO.

AW was founded in the early 1990s and grew rapidly through acquisition, culminating in the merger in 1999 of Allied Waste and Browning Ferris Industries (BFI), which together with the Waste Management/USA Waste deal capped a frenzied era of consolidation in the industry.  Management of the combined AW/BFI struggled to integrate the businesses, which themselves had been built by scores of acquisitions, a struggle that was exacerbated by a very heavy debt load. 

The Board finally ousted the longtime CEO and replaced him in 2005 with current CEO John Zillmer, who was recruited from outside the industry.  Zillmer has essentially implemented the WMI playbook by focusing on streamlining operations, driving efficiencies and pushing price, boosting ROIC and repaying debt.  In the four years through 2007, AW reduced its debt load by $1.6 billion.  As a result, the Company has raised free cash flow (defined as OCF less capex)  considerably despite the continued drag of reinvestment in AW’s infrastructure (especially vehicles), which had been neglected for some time and had begun to impact productivity.  This catch-up element of capex should start dissipating, which together with the operational improvements and pricing improvements should drive FCF materially higher in 2009 and beyond.  As you can see from the figures below, AW management has raised margins despite the headwinds from a substantial increase in fuel costs (which the Company has done a great job of passing along to customers, but it still has a downward impact on margins).  In addition, AW has beaten Street estimates for three quarters running as it continues to execute on its plan and exceed expectations; I expect it to continue to do so.

                              2006                2007                2008E              2009E

Net Sales              $6,029             $6,093             $6,200             $6,450

Adj. EBITDA            1,567               1,656               1,750               1,860

% Margin                 26.0%                          27.2%                          28.2%                          28.8%

Adj. EPS                  0.56                 0.80                 1.00                 1.12

FCF                         191                  396                  420                  500

Price                  $10.12 (10/6 close)

Shares                  434.5

Market Cap          4,396.7

Net Debt               6,320.0

TEV                        11,716.7

TEV/EBITDA (08/09)          6.7/6.3x

P/E (08/09)                                    10.1/9.0x

FCF Yield (08/09)             9.6/11.4%

Despite the vast improvement to the business and de-risking of the balance sheet in the past two years, AW essentially is trading where it was two years ago.  Obviously, the macro outlook has deteriorated, but the waste sector has already seen a decline in volumes over the past year reflecting the slowdown in construction.  Moreover, the core MSW piece of the industry is relatively stable, and the sector should continue to benefit from the price discipline being imposed by the majors.  The sector historically has traded at an average EBITDA multiple of about 8x, and as AW’s turnaround becomes more apparent and industry volumes firm in 12-18 months, the stock should migrate to those historical valuation levels, providing a potential double, with relatively modest downside form current trading levels.

Although my writeup is not predicated on the AW/RSG deal closing, I expect it to close and to be a catalyst for the stock, which has been trading at about a 15% discount to the exchange ratio of the deal (0.45 shares of the combined company for each AW share).  The deal will create a Company that is a strong #2 to WMI, with better growth prospects.  Moreover, AW shareholders will get the benefit well in excess of the $150 million stated synergy goal, an investment grade rated balance sheet, a dividend and a substantially more liquid stock.

Catalyst