Description

Casella Waste Systems (“CWST”) is an undervalued regional waste management company trading at a 20% discount to the industry average with a successful activist involved that is looking to unlock value.  JCP Investment Management (“JCP”) has filed a 13D seeking three Board seats with the likely outcome that JCP wins and the company is sold at a price 50-90% higher than its current share price. 

CWST currently trades at 7.5x 2015E EBITDA, a 20% discount to the publicly traded peer group.  The reason for this significant discount is apparent when performing a simple benchmarking analysis using the publicly traded waste management peers.  As the company is at the end of a three year operational turnaround, CWST is at an inflection point with earnings set to improve going forward.  

Background

CWST is a regional, vertically-integrated solid waste services company.  It was founded in 1975 by the current CEO, John Casella, as a single truck operation in Rutland, Vermont.  Over the last 40 years, it has expanded its operations through acquisitions, moving into New Hampshire, New York, Massachusetts, Maine, and Pennsylvania growing the company to be the 12^th largest waste company in the US.  It currently operates 35 solid waste collection operations, 44 transfer stations, 18 recycling facilities, 10 landfills, and 4 landfill gas-to-energy facilities. 

The company went public in October 1997 at $18.00/sh with the shares doubling over the first year as the company grew topline through acquisitions.  In 1999 the company announced they would purchase KTI, a waste services company, doubling CWST’s revenue.  As a prelude for future capital allocation decisions, the company purchased KTI for $189mm in stock, only to take an impairment of $80mm related to the acquisition the following year.  (Over the course of the last 2 decades, the company has spent $359mm in cash on acquisitions and has taken write-downs and impairments of $230mm.)

The company continued its acquisition spree with a vision to develop other lines of business such as recycling and waste-to-energy.  In order to execute on that vision, the company levered up in the early 2000’s with the intent to harvest free cash flows in the late 2000’s.  Unfortunately their capital acquisition skills are poor and the business didn’t perform to expectations and they were hit by the Great Recession causing EBITDA to fall from $124mm in FY 2008 to $88mm in FY 2013 which caused leverage to go from 4.5x to 5.6x during a time their debt was maturing.  As a result, the company scrambled to refinance selling assets to pay down debt, issuing equity, and accepting a refinancing at punitive rates.  The company also changed management with the promotion of a new Pres/COO and CFO in December of 2012 to turn the business around. 

Since joining, the new Pres/COO Edwin Johnson (“Ed”), and the new CFO Edmond Coletta (“Ned”) have implemented initiatives to turn around the business.  Ned has focused on the balance sheet pushing out debt maturities to 2019 and later, giving Ed time to improve operations.  Under previous management the company had moved towards a centralized management strategy.  This model does not make sense and Ed has transitioned back to a regional management strategy, positioning the company to be able to push price and improve margins in the business.  In addition, Ed has culled unprofitable customers from collection routes, is increasing route optimization, and has implemented a fleet plan to help reduce costs.  These improvements can be seen in the company’s EBITDA margins which are expected to improve almost 200bps in 2015.  In addition, the company is gaining traction on overall collection pricing reporting pricing up 2.8% yoy and they have stated that this trend will continue.  The company is at an inflection point with free cash flow turning positive this year and will continue to grow as operational initiatives take hold. 

While we believe that Ed and Ned have done a solid job turning the business around, John Casella, the Ch/CEO, is still running the business.  Given John’s track record at the company and his Board of cronies, we believe someone else needs to be in charge of the business to protect the nascent turnaround. 

Enter JCP

JCP is an activist fund that has been successful in multiple activist campaigns winning Board seats at The Pantry (2014), Morgan’s Foods (2013), and Jamba (2015).  Both Morgan’s Foods and The Pantry were sold subsequent to winning Board seats.  In addition he advocated exploration of strategic alternatives at AmREIT in 2014, which was sold later in the year. 

On April 28, 2015, JCP filed a 13D notifying CWST of its intention to nominate three independent directors.  In their press release, they note the company’s poor total shareholder returns compared to peers, abysmal corporate governance, and poor operating performance. 

JCP is looking to replace John Casella (Board member since 1977), John Chapple III (Board member since 1994), and James McManus (Board member since 2005) with the following candidates: 

1.       Brett Frazier – a retired Waste Management, Inc. executive.

2.       Joseph Swinbank – a partner in a Texas waste management company based in Houston.

3.       James Pappas – Managing member of JCP Investment Management

On May 29, 2015, JCP filed an amended 13D noting that it owned 2.1mm shares or 5.3% of the company, making them the 5^th largest investor (note that 12 West Capital incorrectly shows up on Bloomberg as the largest shareholder, but owns zero shares).  In the amended 13D, they attached a letter noting that they had been contacted by “multiple potential strategic acquirers of Casella, each with unquestionable financing abilities.”  While he doesn’t name names, you can infer that these strategic acquirers are the four publicly traded waste management companies, all of which are investment grade. 

While this may seem fortuitous timing, our conversations with multiple industry participants have all noted that CWST would not be a public company if not for John.  One ex-CFO of a publicly traded waste management company noted that “there would have been multiple companies that would have taken him out over the last 15 years, but because John doesn’t express interest, there’s no interest from anyone to buy them.” 

In an industry that has consolidated over the last three decades (top 10 firms now account for 84% of the top 100 waste companies in the US, compared to 44% 10 years ago), CWST is one of the last large independent regional waste operators.  We believe that if JCP wins, the company will be put up for sale in the near term.

What is this worth in a sale?

In our conversations with industry executives, deals occur at 15-20x EBITDA-MCX.  Using the low end of that range, and management’s 2015 EBITDA targets, we get the following range of values:

We spoke with an ex-CFO of a publicly-traded, integrated waste management company and he noted that when he left they were targeting a 12-14% ROI with some portion of hard synergies included in the deal EBITDA.  Using his estimate of likely hard synergies, and based on a 13% ROI target, we get the following:

In addition to the $20mm of hard synergies, there would be additional CX synergies from scale in fleet purchases and operational synergies from being able to invest in IT systems that CWST has not been able to make.  Looking at historical deals, acquirers have been able to save 3-7% of sales in operational synergies depending on geographic overlap, which would equate to $16-37mm of synergies for an acquirer of CWST.  We believe given the historical mismanagement of CWST, that there would likely be even more synergies than our estimate.

One last way we triangulate to fair value is that historical deals typically take place at the industry average multiple at the time.  

What is it worth as a standalone?

CWST has historically traded at a 1 turn discount to the peers (RSG/BIN/WM).  So on FY 2015 numbers, CWST is worth 7.8x $105mm in EBITDA.  That gets you to a $6.84/sh price or +21%.  As we move forward, the company has several initiatives that will drive earnings going forward. 

As with most waste companies, recycling has been a headwind to earnings due to recycled commodity prices declining significantly over the last few years.  Because of CWST’s outsized exposure to recycling, the impact at CWST has been more severe.  Management is now working to earn an adequate return on recycling assets through higher tipping fees at their recycling facilities, putting in place an adjustment fee to collection customers based on the commodity prices that CWST actually receive, and improving recycled processing costs.  This will add $6mm of EBITDA once fully implemented over the next two to three years.

In addition, CWST’s eastern market is projected to be in a disposal capacity shortfall by 2018 due to landfill closures which will allow the company to raise price.  We estimate that for every 1% increase in price for eastern landfills tons, adds $0.7-$1.0mm to EBITDA.  Over the past two years, the company has been able to increase price across all of their tons by ~3.5% annually with the company noting that price per ton in Q115 for eastern landfills increased 6%.  If the company is able to advance pricing cumulatively by 5% over the next two years that would add an incremental $5mm to EBITDA.  Rolling things forward, in two years EBITDA could be $11mm higher, which would value the standalone company at $8.89/sh, or +58%.  In addition, 100% of excess free cash flow should be used to pay down debt, accreting value to equity holders.

While the positive impact to CWST outside of a sale if JCP were to control 3 Board seats is unknowable, there are likely further improvements that could be made to the business.  JCP’s letter notes that there have been over $70mm in payments to John and his brother Doug’s privately owned construction business over the past decade.  Additionally, some of the changes made by the new Pres/COO and CFO are shocking – for example, a new head of IT switched the company from Lotus Notes to Microsoft Outlook in the last 12 months, highlighting how little attention past management paid to core operations.  With John out of the driver’s seat, earnings should improve materially as the company is run for shareholders rather than as a family business.  

We expect the company to highlight this earnings ramp on their Q2 earnings release conference call in early August as they publicly commented they will share their financial plan (see conference calls from Stifel WasteExpo and the KeybBanc Capital Markets Industrial, Automotive & Transportation Conference over the past month).  The conference call transcripts are available on Bloomberg and include interesting commentary from management. 

 How likely is it that JCP wins?

Normally a CEO with a poor track record like John Casella would have been forced to resign, but a dual class share structure,  a staggered board, combined CEO/Chairman, and a stagnant Board (14 years is the average age of a Board member) allowed John Casella to stay on as CEO.  Between John and his brother Doug, they own 2.2mm of the class A shares, and 1.0mm of the class B shares, which in total represent 8% economic interest in the company.  With class B shares having 10x the voting rights of the class A shares, they control 24% of the vote.  Together with other executives and directors, management has an 11% economic interest in the company and 26% of the vote.  John and Doug’s control of the vote has lessened over time due to equity raises by the company diluting their voting control which allows an activist like JCP to fight for Board seats. 

Counting votes, we believe that JCP and other large shareholders have equal footing with the company at roughly 25% of the vote.  That leaves 50% of the vote that could swing either way.  In JCP’s 13D, they note that proxy solicitors view the company poorly.  ISS rates CWST at a 9 (from a scale of 1 to 10), the second worst score.  Given the quality of JCP’s nominations, the proxy solicitor’s poor rating for CWST, and the track record of the CEO’s value destruction compared to the track record of JCP’s value creation, we think it likely shareholders will vote for JCP.  It seems clear that the company has a similar view as they have delayed the annual meeting.

Putting it all together

CWST is an undervalued waste management company with multiple strategic acquirers that would be interested in acquiring the business. 

Additionally, we think it’s possible that CWST could also announce the exploration of strategic alternatives.  On a conference call in early 2014, Ed noted that “from a practical perspective when we look at where we could be in three years, it doesn’t make a lot of sense strategically to sell the company today.”  More recently, just last month at the Stifel WasteExpo Conference, John noted “I think certainly that’s a real possibility” when asked if the sale of the company is one of the multiple options on how to extract shareholder value.  It would be better for John to sell while on top instead of a sale happening after he loses control of a company with his name on it.  

Risks

Proxy contest – JCP losing the proxy contest would be a negative as there would be no catalyst to unlocking value other than increased earnings.

Economic downturn – Residential and commercial waste are tied to the overall economy.  A recession would put pressure on tons of waste created and on price per ton.  This combined with the high leverage would likely cause another round of dilution.

Execution – Inability to turn recycling around or realize price increases in the company’s eastern geographic footprint. 

Catalyst

• JCP winning the proxy contest
• Exploration of strategic alternatives
• Increased earnings/FCF