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Morningstar | Healthy Pricing and Higher E&P Waste Activity Offset Recycling Headwinds in Waste Connections’ 3Q

Traditional solid-waste services specialist Waste Connections posted roughly 2% third-quarter top-line growth on an organic basis, to roughly $1.3 billion, mostly in line with our expectations. Relative to the same period last year, higher revenue was once again the result of highly favorable pricing conditions across the traditional solid-waste industry, along with increased activity for the specialized E&P waste segment. These factors were only partly offset by continued contract optimization efforts and persistent recycling headwinds linked to anemic commodity prices for materials the firm extracts and sells.

Our midcycle revenue and operating margin assumptions remain largely intact, but we expect to modestly increase our fair value estimate by roughly 2% on the time value of money since our previous update. The shares are trading in slightly overvalued territory. Recycled commodity prices are depressed, but several industry leaders are seeing very healthy growth within their solid-waste operations thanks to U.S. macroeconomic tailwinds, and this dynamic hasn’t escaped investors. Waste Connections is a high-quality company but, in our view, the stock price is baking in slightly overoptimistic midcycle revenue and margin assumptions.

Internal growth for the solid-waste operations (including collection, disposal and transfer, and recycling operations) grew 2%, as another solid 4% contribution from core pricing more than offset flattish waste volume and an approximate 2% headwind from weakness in the recycling unit. Recycling revenue fell about 46% year over year (down 46% year to date) on the back of markedly lower average recycled commodity prices, which are under pressure from increased import restrictions in China. E&P waste segment revenue was up 18% due to higher activity with customers in the Permian basin.

Of note, flattish solid-waste division volume trends were the result of the lingering shedding of low-margin Progressive Waste contracts, lower volumes at the firm’s New York City transfer stations (linked to the previous exit of a low-margin contract), and a tougher comparison (third-quarter 2017 benefited from incremental Hurricane Harvey-related activity). Demand is otherwise healthy.

Waste Connections’ adjusted EBITDA margin fell 10 basis points to 32.5%, primarily because of the impact of slightly dilutive acquisitions, as solid waste and E&P margin gains more than offset recycling headwinds. The firm continues to expect adjusted free cash flow of $860 million for 2018.