Construction Boom! Which Waste Company Stands To Benefit The Most?

The market is expecting an increase in house construction and general infrastructure activity. Homebuilder stocks have already priced this in, but which companies stand to benefit in other sectors?

Economic strengthening and tax reform have created a broad increase in American indices. Many industries have seen widespread price appreciation, but homebuilder stocks have seen outsized gains. The price appreciation in homebuilders more than double the growth of the S&P 500.

The optimism extends to general infrastructure, with companies like Caterpillar, Deere, and Hitachi Construction Machinery showing strong price appreciation.

There are many reasons for the broad appreciation in home building stocks. The Globe and Mail wrote on the 30th of November 2017:

"A growing economy, solid job market, low unemployment rate and low mortgage interest rates have helped drive demand for homeownership this year. And a stubbornly thin inventory of homes for sale has kept home prices headed higher. All that has been a boon for homebuilders. Sales of new U.S. homes hit the fastest pace in a decade last month."

The legitimacy of the above hypothesis is unknowable, but the valuation multiples on housing stocks tell a distinct story.

The price-to-sales ratio of homebuilders and industrial machinery has skyrocketed, while profit margins have remained relatively stable (except Caterpillar, whose shareholders benefited from a large profit margin increase, due to operating at 50 bps profit margins previously).

The valuation multiples imply (A) forward sales acceleration and (B) margin expansion. Tax cuts add ~20% to FCF generation and house price increases in good years approximate 5%. With PS ratios increasing 50%, the market is clearly expecting a materially increased demand for housing.

The stock prices of homebuilders partly reflect the forward optimism regarding purchases of new homes, but are there any other ways to benefit from this expected growth?

A safe assumption is that increased homebuilding and infrastructure activity will produce waste. The waste associated with the waste sector is often heavily regulated and requires different handling than common types of solid waste.

There are several verticals in the waste industry that deal with construction waste. The industry term is C&D waste (construction & demolition). C&D waste is a significant part of the aggregate US waste-stream; by some estimates, C&D waste constitutes 30% of US waste.

Which assets are attractive?
Several areas of waste management will benefit from the increased construction activity.

All waste needs to be collected and C&D waste usually requires specific contract work. Both the nature of the refuse (separating hazardous parts, regulatory classifications, etc.) and the impermanence of the location requires irregular operations on part of the waste companies. The barriers to entry on performing collection activities are quite low, as the required assets are inexpensive and easy to obtain. Every major waste company will be able to handle C&D waste, so there is active competition in collection. In urban markets C&D waste is not a very lucrative activity.

The waste also needs to be disposed of. There is a plethora of regulatory decisions that vary by state, but oftentimes C&D waste must be recycled. 70% of all C&D waste was recycled in 2015, which is indicative of the stringent regulatory demands imposed on the construction sector. The Trump administration might lessen the percentage of C&D waste recycled slightly, but the matter is often dependent on state law. It can be said with reasonable certainty that recycling operations will benefit heavily from increased demand. Capacity is fairly easy to build, so it is unlikely that supply will be constrained. It’s likely that recycling revenues will benefit with no incremental margin expansion. An issue to be researched further is recycling legislation being amended due to the recent China ban on certain imports.

The remaining 30% of C&D waste is often disposed in landfills. Landfills have great EBITDA-margins, often 2-5x the ones prevalent in recycling, so while C&D recycling will add the greatest amount of sales, C&D landfills will add the greatest amount of EBITDA. Furthermore, capacity expansion is extremely difficult. Not only are new landfills extremely infrequent, but also C&D waste landfills are even more difficult to replicate. The inherent difficulty in creating a C&D landfill lies in C&D landfills being distinct from regular MSW landfills and therefore requiring different permits. C&D landfills can be either "MSW and C&D" or exclusively C&D; in my experience exclusive C&D landfills are most common. Landfills have high fixed-to-variable costs and thus require significant volume, effectively requiring a significant amount of C&D activity in the vicinity. Combining the stringent regulatory demands with the required volume explains why C&D landfills are fairly rare assets. Increased demand on high-margin sales with limited ability for capacity expansion makes for a very attractive asset.

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