Description

Long Green for Life Environmental (Ticker: GFL / GFL.CN)

“I own too much equity in this to make mistakes now” – Pat Dovigi (CEO), August 13th, 2020

“Show me the incentives and I will show you the outcome” – Charlie Munger

Opportunity Overview

Green for Life Environmental (“GFL”) is a waste services company with Canadian roots that recently IPO’d in March of this year. The company is led by a young, zealous owner-operator, Pat Dovigi (41 years old), who founded the company in 2007. Since its founding, the business has grown from $0 to $5.1Bn in annualized revenues (as of 2020 year-end; pro forma for two large platform deals this year) thanks to its aggressive M&A strategy. GFL has danced with private equity for much of its corporate history, opting to run at 6.5-7x leverage over most of its 13 years as a private company. Since coming public however, mgmt. has committed to bringing that leverage level down to a more palatable level for public markets investors (<4x) and to avoid exceeding ~4.5x for an extended period of time.

The investment thesis and opportunity here is not difficult to understand. On the qualitative side, this is a “bet-the-jockey” type trade where we are betting on the execution of the founder-owner-operator whose incentives are very well aligned with ours as shareholders. On the quantitative side, GFL trades at ~10x forward EBITDA which is a material discount to peers (WM/RSG trade at ~12-13x, WCN/CWST trade at ~17-18x) and a potential private market valuation (~15-16x). From a fundamentals standpoint, this discount seems unwarranted given the quality level of GFL’s assets are no worse than its peers, if not better than some. This is a “show-me” story with a clear path forward and I believe that over time – as the two large deals this year are digested, as leverage comes down, and as FCF flips positive – this discount will close, allowing the stock to nearly double over the next 2.5 years (versus Friday’s close price of $21.38 USD / share). Plus, a boat (yacht?) load of money for Dovigi.

Thesis Point 1) Our incentives as shareholders are very well aligned with the CEO’s

Stock outperformance by companies who are still led by their founder is a well-documented phenomenon. In this case however, not only does Dovigi own a substantial amount of equity already (11.9m shares worth ~$255m), his award package laid out at IPO allows him the possibility to increase his stake to north of $1Bn in just a few years should be able to get the stock close to $40 by around June 2024. You don’t see incentive structures of this magnitude very often.

In my opinion, the size of this incentive plan helps in gaining comfort in the investment case of this company moreso than a similarly sized package at another company would. Given that much of the debate around this stock is around the manageability of GFL’s capital structure given its track record of aggressive use of leverage, knowing how much Dovigi stands to make (or lose) here helps in gaining comfort with the fact that Dovigi is not gambling the company’s future with large/aggressive deals (i.e., the recent WM/ADSW divestiture and WCA deals), but rather is taking calculated risks on high quality assets.

Of note, GFL has a dual-class share structure. 12.1m untraded super voting shares (11.9m owned by Dovigi) each have the right to 10 votes per share, while the publicly traded shares have an equivalent economic interest but only 1 vote per share. Fortunately, the super voting shares only amount to ~28% of total votes, so public market investors are not completely captive.

Thesis Point 2) Both existing and newly acquired assets (WM/ADSW divestiture and WCA deals) are of high quality and no worse than peers

The waste business is an envious one to be in. Given that they provide an essential service, players in the space enjoy resilient underlying market demand through economic cycles (industry-wide solid waste revenues tend to go down only modestly (sub MSD declines) in economic downturns) while also throwing off bond-like cash flows. The waste game is all about route density (the denser your routes, the lower your marginal cost), M&A (the North American waste industry is still fairly fragmented despite more than a decade of consolidation), and price control. Volumes ebb and flow but over the longer term are generally only flat-to-slightly up. The more important driver of revenue growth in this industry is price growth, which typically runs in the 2-5% area. Players that have more exposure to less competitive secondary markets (ie, WCN) are able to get away with pricing towards the higher end of the 2-5% range, while others that have more exposure to more competitive urban markets (ie, WM and RSG) are often only able to grow price ~2-3%. Waste services contracts vary by geography and customer type but are typically multi-year in duration and include stipulations of price growth based on a spread above CPI growth.

While, admittedly, WCN seems to have the highest asset quality/competitive positioning of all the waste companies (due to their scale, heavy exclusive markets focus, and concurrent landfill ownership), GFL’s assets are not that much worse off. In the tables below, you can see several different ways to look at revenue composition between peers. GFL has a smaller asset base than its peers, but they are concentrated in a few key geographies (East/West Canada, US South East, US Midwest; 50/50 US/CAN split) which still allows GFL to benefit from route density just as its larger peers do.

The recent WM/ADSW divestiture (announced Jan 2020; to close in 3Q20) and WCA (announced last week; to close 4Q20) deals bring more high-quality assets under the GFL umbrella. The assets of the first deal, which were mandated to be divested for antitrust reasons related to the WM/ADSW merger, are mostly located in WI (complementary to GFL’s existing Midwest presence) and are of such high quality that “they never would have gone on sale” had the WM/ADSW divestiture not happened. The bulk of the assets included in the WCA deal, announced just last week, are located in TX, MO and FL and are also highly complementary to both the WM/ADSW divestiture assets (the non-WI assets) and GFL’s pre-existing asset base.

The two big deals this year together have costed GFL ~$2Bn and bring in ~$280m in annualized EBITDA. 2020E net leverage pro forma for the 2 deals is 4.6x and GFL opted to fund part of the WCA deal with a $600m preferred offering (to HPS Investment Partners; convertible to common equity at $25.20) so as to cap leverage at around the ~4.5x level that mgmt. committed to at IPO. Despite the higher cost of capital associated with a preferred offering, I view the deal favorably given the vote of confidence it shows from HPS. HPS has been a long-time private equity partner of GFL’s, having bought into the equity at ~$3/share in 2014 and sold out for ~$12/share in 2018. Despite already quadrupling their money already, HPS coming back into the equity at effectively ~$25/share sends a strong message as to the future value creation potential they see here.

Thesis Point 3) GFL’s valuation discount versus peers will close over time

On Street numbers, GFL trades at ~10x 2021 EBITDA, while peers trade at 12-18x 1-year forward EBITDA.

I see 3 main factors driving GFL’s discounted valuation, each of which should improve over the next few years thereby closing the gap versus peers.

First, GFL has lower margins than some if its peers. This is driven by GFL’s historically greater exposure to faster-growing but lower-margin soil remediation and liquid waste revenues and less exposure to higher margin landfill revenues. GFL’s margin profile has improved meaningfully over the past 5 years and fortunately, the two large deals announced this year increase GFL’s relative exposure to higher margin revenue streams – solid waste collection and landfills. EBITDA margins pro forma for these two deals is 26.3% and should gradually inch up closer to peers as GFL continues to grow via above-peer price growth, which drops down to EBITDA at high incrementals. Within the next 5 years, I would not be surprised to see EBITDA margins approach ~30%.

Second, as discussed, GFL has higher leverage than peers. However, even with GFL’s tuck-in M&A program (~25-30 deals/year in the $1-10m EBITDA range, acquired at ~7x EBITDA), the business should naturally de-lever by about half a turn each year. This means that by around 2023 year-end, net leverage will approach the low 3’s area which is not far from peers.

Third, GFL has a limited history of generating any free cash flow given the leverage level they’ve operated under while private and their relatively high cost of debt they’ve issued in the past. GFL’s FCF margin over the past 5 years has been around -5% while peers typically operate at around 15%. FCF is flipping positive this year however, and is guided to come in at ~$340m (excluding ~$150m in IPO-related costs), or a ~8% FCF margin. GFL has publicly called out several low hanging fruits in terms of refinancing their capital structure that they can use to lower their interest costs and bring up that FCF margin even more. Over the next few years, GFL’s FCF margin should approach ~15%, in-line with peers.

Valuation

While I do have a more detailed model, the calculus here on forward returns is relatively simple and can be done on the back of a napkin. On the WCA call this past week, mgmt. hinted at $1.4-1.5Bn in EBITDA in 2021. I’m using the midpoint of this range as the starting point to case out the returns going forward.

In a base case scenario, I assume 2% organic growth (0% volume, 2% price) in both 2022 and 2023. I assume $100m in EBITDA is acquired each year at 7x and entirely debt funded.  I add this debt on top of the debt implied by mgmt’s comment on last week’s WCA call that net leverage would reach the low 3’s by 2023. So my net debt figure in this case is $1.7Bn x 3.25 + ($200m x 7) = ~$6.9Bn. I assume all of management’s incentive awards vest (17.7m for Dovigi, 1.3m for the CFO, and 0.5m for the COO) and HPS converts its preferred into common equity. Using a 15x forward EBITDA multiple (the average of the 4 main peers), I get to a ~$38 USD stock price, or ~80% upside from Friday’s closing price (26% IRR).

My bull case scenario assumptions are largely inline with the base case assumptions, except that I assume organic growth is 3.5% and $150m in acquired EBITDA in each 2022 and 2023. Using a 17x forward multiple (high end of peers, inline with WCN and CWST), I get to a ~$48 USD stock price, or ~120% upside (38% IRR).

In my bear case scenario, I assume the business goes nowhere in 2022/2023, no deals are done, and that the forward multiple stays flat at 10x 1-yr forward EBITDA. I assume Dovigi only gets a piece small piece of his incentive awards and I assume the HPS does not convert its preferred shares into common equity. Under these assumptions, I get to a stock price roughly in line with where it is today.

Risks

-         Issues integrating WM/ADSW divestiture and WCA deals (mgmt. has done 140+ deals since its founding, so this is not too concerning)

-         Mgmt not sticking to the plan that they have communicated

-         Industry-wide sustained negative pricing environment

Catalyst

-         Integration of WM/ADSW divestiture and WCA deals

-         B/S deleveraging over time

-         Margin expansion and consistent positive FCF generation.