Description

Waste Industries is a well-run regional waste management business that has sold-off recently in response weak results that are due primarily to short-term issues. The business is a good one, and is undervalued at 5.5x 2006 EBITDA and 12.5% 2006 FCF yield. In addition, a buyer of WWIN receives several free lottery tickets that could prove valuable. One landfill development project in particular has a reasonably high probability and could be worth $3 to $10+ per share. Finally, though the investment thesis does not depend on this, there is an increasing likelihood of a corporate event (recapitalization, management buyout, sale of company) due to the retirement and increasing frustration of the company’s founder and majority shareholder.

WWIN was submitted to VIC by paddy788 almost two years ago. Since then, there have been several positive developments, which I think outweigh the short-term difficulties. The 10-K and paddy’s write-up provide a good background on the company, so I will focus on what is new.

1. Weak Q2 Results

WWIN’s margins in recent quarters have been depressed by several items, and the impacts of these things were particularly severe in Q2. As a result, the Q2 EBITDA margin dropped to 17.4% from 20.0% last year. The share price has declined as if this is permanent, but I believe it is temporary.

The biggest culprits in the margin decline were higher fuel costs (130 bp), Sarbanes-Oxley expenses (80 bp), non-recurring “professional” fees (60 bp), and non-recurring operating losses at the recently-divested Atlanta operations (50 bp).

WWIN’s average diesel cost in Q2 was 35% higher than last year. WWIN typically recaptures fuel cost increases on most of its contracts through fuel surcharges, but there is a lag effect. The rapid increase in the price of diesel this year has meant that the lag has been very pronounced.

WWIN estimates that Sarbanes-Oxley will cost it $2.6-2.8 million this year. The incremental cost in Q2 versus last year was $600k. The costs will remain elevated through Q1 of next year, and then should decline to below $1.0 million on an annual basis.

WWIN incurred nearly $500k of “professional” fees in Q2, much of this related to a DOJ anti-trust inquiry in the Tidewater, Virginia market. WWIN and the DOJ reached a resolution in early August, whereby WWIN agreed to divest a small number of customer accounts (less than $1 million of revenue). The rest of the professional fees are also non-recurring, mostly for expenses related to the Atlanta transactions and relocation of personnel to Atlanta.

I will discuss the Atlanta operations more below, but the important point here is that the Atlanta operations WWIN acquired in December and swapped away in June operated at a $150k monthly loss. The new operations that WWIN received in the June swap operate at a $100k monthly profit.

Adjusting for all of these items, the EBITDA margin would have actually been higher than last year (21.0%). Looking forward, if we assume that half of the fuel increase can be recaptured through fuel surcharges, that Sarbanes-Oxley expenses drop to next year’s run-rate level, and that the new Atlanta operations achieve expected profitability, my estimate of a run-rate margin is 20.0%.

2. Geographic Focus

WWIN has made great strides in its geographic focus over the past few years. Through a series of asset swaps and small acquisitions and dispositions, WWIN has exited several non-core markets (Biloxi, MS; Olive Branch, MS; Crossville, TN; Sumter, SC; Charlotte, NC) and focused on its three primary markets: eastern North Carolina, the suburbs west of Atlanta, and southeastern Virginia. WWIN is now a major player in these markets, and its local scale provides it with competitive benefits and the opportunity to boost margins.

Asset swaps are regaining popularity in the waste industry, and WWIN has been a leader in this respect. In the past two years, WWIN has completed swaps with Allied Waste, Waste Connections, and Waste Management.

The Atlanta market is a good example of WWIN’s new geographic focus and the benefits of swaps. WWIN experienced mediocre performance in Atlanta for years because it lacked scale and was not able to internalize (put into its own landfill) the waste it collected there.

Following its acquisition of the Grady Road landfill from Waste Connections in December, WWIN has taken several steps to consolidate its power in the suburbs west of Atlanta. Through a series of swaps, WWIN and its major competitors have effectively divided up the Atlanta metro region. WWIN traded its assets north and east of Atlanta in return for operations on the west side. WWIN has also made a number of small tuck-in acquisitions, which will further increase its route density and allow it to direct more waste to its landfill (both of which should lead to better profitability).

WWIN deferred integration of its Atlanta operations until it could complete the final swap with Waste Management, which just closed in June. This took several months longer than expected, and in the interim WWIN absorbed operating losses of $150k per month (mostly from some operations it acquired along with the landfill in December, and that it never intended to own very long). The integration is underway, and should be complete by the end of the year.

3. Valuation

At $12.50, WWIN trades at 6.0x 2005 EBITDA and a 4% FCF yield. Both EBITDA and FCF are depressed this year for the reasons mentioned above, and FCF is further depressed due to significant spending on landfill expansion projects (these occur every several years at each site, and several happen to coincide in 2005). Looking to 2006, I expect EBITDA to increase to $63 million, and the multiple drops to 5.5x. This EBITDA number implies a 19.2% margin, which would represent an improvement from this year, but is still below the 2004 level (and also below the 20.0% run-rate I calculated above due to Sarbanes-Oxley expenses that will carry into Q1 2006). Assuming a normal level of capital spending of $26 million (equal to the average annual capex from 2001-2004), I project 2006 FCF to be $22 million, which equates to a 12.5% yield.

The value to an acquiror provides another look at valuation. In an LBO, I think a buyer could pay as much as $18 per share. This assumes 5x leverage, minimal cost savings (just that Sarbanes-Oxley expenses go away), and an exit multiple of 6x trailing EBITDA. Given the cost savings a strategic buyer would enjoy, and the fact that most public companies trade at higher multiples and can use stock as currency, it is not difficult to get to a price well above $20 for a strategic buyer. WWIN would be a good geographic fit for several larger companies.

4. Free Lottery Tickets

I refer to these as lottery tickets because they have relatively low probabilities of providing large payouts. Even if all of these prove to be worthless, I expect an investment in WWIN to do very well.

WWIN is in the late stages of permitting for a new regional landfill in Camden County, NC (the "Black Bear" landfill). WWIN has a franchise agreement from the county and is awaiting a site suitability permit from the state. From what I understand, the final sticking point has to do with the legal structure of the entity that will be named on the state permit, and WWIN is discussions with the NC attorney general on this issue. WWIN is optimistic that it will get the suitability permit by the end of the summer, though there remains local opposition and nothing is certain until the permit is actually issued.

If the Black Bear landfill goes forward, it could be huge for WWIN. A detailed model is required to accurately value the landfill project due to its long life and lumpy stream of cash flows. A simple version of the most conservative case looks as follows: 2,000 tons per day x 275 days per year x $28 per ton x 50% EBITDA margin = $7.7 million annual EBITDA. A landfill of this size would cost about $24 million upfront to construct ($9 million of this has already been spent, mostly to buy the land) and then would be self funding. Even at this small scale, the project would have a very good ROI and would have a major impact on consolidated EBITDA (which I project to be $63 million in 2006, excluding any benefit from Black Bear).

I think the homerun case would involve importing about 6,000 tons per day by barge from NYC (note that the landfill would actually be permitted to receive up to 10,000 tons per day). The simple math at this scale would be: 6,000 tons per day x 350 days per year x $20 per ton x 70% EBITDA margin = $29 million annual EBITDA. This would cost over $50 million to construct, but clearly would be an excellent investment.

The other lottery tickets involve potential landfills in Wake County, NC and Nashville, TN. While both would be meaningful, I would assess them as low probabilities (it appears that the Wake County project will be awarded to a competitor, and Nashville is tied up in litigation).

5. Possible Corporate Event

Let me repeat that this investment does not require any sort of corporate event to turn out well, nor do I necessarily expect an event. WWIN is a $175-million company (equity market cap) that operates in a stable industry, should generate over $20 million of FCF on a sustainable basis, and has numerous reinvestment opportunities. That is enough for me, but the possibility of an event to accelerate returns is obviously positive.

WWIN has long been rumored to be an acquisition target, but its founder (Lonnie Poole, Jr.) has never wanted to sell. So what has changed? Several things: (a) Mr. Poole now has limited involvement with the company. Since retiring as CEO in June 2002, he has progressively reduced his role, and now comes into the office just once every few weeks. (b) Mr. Poole’s two sons are more inclined to sell than he is. Both have been sellers of their shares, and the one that is involved with WWIN (Ven Poole, VP of corporate development) is a co-founder of a growing real estate company to which he might want to devote all his time at some point. (c) Mr. Poole is increasingly frustrated with the low share price and he wants some liquidity. I have never discussed this point directly with Mr. Poole, but I have discussed it with the rest of the management team, and there has been a definite shift in Mr. Poole’s outlook and patience over the past year. (d) WWIN a few weeks ago entered into a new employment agreement with Mr. Poole that provides for compensation in the case of a change of control or if he is required to be based more than 35 miles from the current headquarters. Prior to this, Mr. Poole was the only executive that did not have a change in control agreement.

I don’t expect anything to happen until the Black Bear landfill situation is resolved. This is because the landfill would make the company much more valuable and would require significant capital. If Black Bear does not come to fruition, I think the probability of an event is high.

6. Risks

In addition to the environmental risks associated with the industry, I think the primary risk is that the company squanders its FCF. I worry that management is not as sophisticated as I would like when it comes to capital allocation. This risk is ameliorated somewhat by the fact that WWIN has shown good discipline in the past few years under CEO Jim Perry’s leadership, and that WWIN’s most likely investment opportunities (Black Bear landfill, debt reduction, tuck-in acquisitions, dividends) generally offer at least decent returns.

Catalyst

1. Margin improvement after fuel surcharges recapture some of the year-to-date fuel cost increases, Sarbanes-Oxley expenses decline to run-rate, and Atlanta operations are integrated.
2. Receipt of site suitability permit for Black Bear landfill.
3. Potential corporate event (recapitalization, management buyout, sale of company).