Waste Connections: Waste margin improved 80-90 basis points (NYSE:WCN)

I updated my “Buy” thesis for Waste Connections (NYSE:WCN) in March 2024, indicating strong margin expansion and price growth. Waste Connections released its second-quarter fiscal year 2024 results on July 24^treporting 11.2% revenue growth and 16.4% EBITDA growth. As the company exits lower margin contracts, I predict Waste Connections will sustain price growth and improve waste margins. I reiterate a “Buy” rating with a fair value of $200 per share.

Waste margin improved by 80-90 basis points

The biggest takeaway from the quarter is the company’s strong price execution and solid M&A pipeline. As shown in the chart below, Waste Connections saw a 7% increase in base prices, accompanied by a 2.8% decrease in volume. As I mentioned in my previous article, Waste Connections intentionally terminated unprofitable and low-margin contracts with some customers, resulting in a better margin profile and lower volume growth.

During the press conference, management revealed that solid waste margin improved by 80-90 basis points during the quarter. The strong improvement in margin is driven by several factors:

• The termination of unprofitable contracts is a key driver of margin growth. Due to prior acquisitions, Waste Connections had several low-margin contracts, and the company decided not to renew those contracts unless it could negotiate better prices with customers. I consider the contract review initiative to be a very smart strategic move.
• In my opinion, Waste Connections has been optimizing its outsourced service cost structures and consolidating some service providers, which has further contributed to the overall margin growth.
• Finally, Waste Connections indicates that they have begun to see cost inflation ease compared to the global pandemic. Labor shortages and costs are now improving due to the overall weakness of the labor market.

Thanks to these three factors, Waste Connections saw margin improvement of 80-90 basis points in its solid waste business, which is quite an impressive result.

Strong M&A channel

Because Waste Connections did not repurchase any of its own shares in FY23, the company increased its M&A activity in FY24. On the earnings call, management projected that M&A would generate an additional $700 million in revenue in FY24, and it currently has a very strong pipeline. The company has already spent $1.5 billion on acquisitions year to date, exceeding its annual total of $676 million in FY23. I support the company’s acquisition strategy of matching to further consolidate a fragmented market for the following reasons:

• Waste Connections prefers small and complementary transactions that are easy to integrate and generate cost/revenue synergies. For example, in February 2024, Waste Connections purchased assets from Waste-Away Group, a waste management company serving northern Indiana and southern Michigan. This is a fairly small acquisition for Waste Connections; however, the transaction could help the company expand its waste management services in Indiana.
• Despite these acquisitions, Waste Connections maintains a solid balance sheet, ending the quarter with a debt leverage of 2.67x. As I calculate, the company will generate over $1.2 billion in free cash flow, Waste Connections has ample capital for acquisitions, share repurchases, and dividends.

Outlook and valuation

For fiscal year 2024, Waste Connections projects total revenue and net income of $8.85 billion and $1.087 billion, respectively, as detailed below:

I take into account the following factors influencing their short-term growth:

• Pricing: I anticipate that Waste Connections will continue to maintain disciplined pricing for both renewals and new contracts. Historically, during normal inflationary periods, Waste Connections has generated price increases of about 4.4%. This price increase is sufficient to offset rising labor and commodity costs in a normalized economy. Given these factors, I anticipate that Waste Connections will generate a 4.5% price increase going forward.
• Volume: Once Waste Connections completes its contract margin review, I expect volume growth to return to historical averages. Investors should not expect significant organic volume growth, as it is primarily driven by new contract wins and organic waste production growth. I anticipate volume growth of 0.5% going forward.
• M&A: With Waste Connections already spending $1.5 billion on acquisitions this year, fiscal 2024 is shaping up to be a record year for M&A activity. I expect Waste Connections to spend 10% of total revenue on acquisitions starting in fiscal 2025, which would translate to a 5.5% increase in overall revenue.

As a result, I estimate that Waste Connections revenues will grow by 10.5% per year. I calculate that the company will achieve a 22.8% operating margin by FY33, assuming:

• 10 basis points on gross profit thanks to positive price-cost spread;
• 10 basis points from SG&A operating leverage
• Assuming the company’s depreciation expense remains at 11.8% of net fixed asset value, depreciation expense as a percentage of revenue is expected to decline from 9.6% in fiscal year 2024 to 7.9% in fiscal year 2033.

Using these parameters, the DCF can be summarized as follows:

The weighted average cost of capital (WACC) is calculated at 7.5% assuming: risk-free rate of 3.7%; beta of 0.56; cost of debt of 7%; equity risk premium of 7%; equity of $47.7 billion; debt of $6.8 billion; tax rate of 23%. Fair value is calculated at $200 per share at a discount rate of 7.5%, consistent with my DCF model.

Key Risk

In March 2024, the U.S. Environmental Protection Agency (EPA) issued interim guidance for the disposal of certain perfluoroalkyl and polyfluoroalkyl materials (PFAS). The new regulations could potentially increase the cost burden on landfills. During a press conference, management estimated that PFAS-related costs could increase by $2 million to $4 million per landfill. Ultimately, these additional costs will be passed on to end customers who dispose of these PFAS materials. While the new regulations could increase Waste Connections’ operating costs in the short term, I am not concerned about their overall impact on the company’s margin profile.

Application

Waste Connections is well-run, with the current management team prioritizing profitability over pure volume growth. I am a fan of their tuck-in acquisition strategy and strong M&A pipeline. I reiterate my Buy rating with a fair value of $200 per share.