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Industry Analysis: Environmental
There are two major types of companies included in our Environmental Industry. One group consists of the largest operators, in terms of revenues and market capitalization, which provide waste collection and disposal services to municipalities and businesses. Their collection routes and landfills are found in most regions of the United States. This segment is less cyclical than most other areas of the industry, due to the long-term nature of contracts, particularly those with municipalities, and the basic necessity of disposal. That said, companies in the Environmental Industry are subject to swings in domestic construction activity and unusual events, such as hurricanes. Even "normal" waste streams can be affected by an economic slowdown, since both consumption and business activity decline. Consolidation is a factor that has lent a degree of stability to the industry.
The other major group in the Environmental Industry provides various services, including the removal of toxic waste from soil and pollutants from air and water. Another example would be companies that specialize in serving medical practices and the removal of medical waste. These companies generally experience wider swings in year-to-year earnings comparisons than do the collection and disposal giants. Accordingly, their share prices are also more volatile.
Environmental companies may increase revenues via internal or external expansion. In good times, managements might develop new collection routes and landfills, and add customers. During tough periods, when business is soft, the companies usually rely more on rate hikes to support the top line. Large and financially strong operators typically have greater pricing power. Too, well-heeled companies frequently step up their acquisition activity under a difficult economic climate. In addition to price increases, companies sometimes implement fuel surcharges, depending on the price of diesel - a major cost component of operations. The performance of companies serving certain environmental niches, such as filtration, medical, and engineering and consulting, may not coincide with the broader industry business cycle.
Operating margins across the industry are fairly robust. Indeed, it is not unusual for margins to average almost 25% on a multiple year basis. This level reflects the high capital cost and entry barriers to new competitors. Such a situation has allowed the industry leaders to act aggressively on the pricing front, when faced with rising costs. Landfill capacity is limited, and thus a high-value asset. Maintaining an efficient, youthful truck fleet (and fuel surcharges, if needed) lends support to margins, as well.
An important operating metric for companies in this industry is the internalization rate, or the percentage of waste disposed in landfills. Acquisitions of smaller neighboring collection companies can enhance the internalization rate and profitability of large operators. Too, accumulated technological expertise can provide a competitive edge and, hence, a barrier to entry. The ability to offer niche services often helps to maintain very healthy margins, as well.
On the whole, cash flow of companies in this industry well exceeds their capital budgets. Depreciation (which includes landfill amortization) frequently approximates capital spending. Free cash flow is essentially net profit less dividends. We note that these companies have tended to use the bulk of free cash flow for singular purposes. For example, funds may be primarily directed at stock repurchases, debt repayment, or acquisition activities.
Large players typically have long-term debt-to-total capital ratios of around 50%, indicating that financial leverage, while not excessive, is important to their operating strategy. On the other hand, leverage is usually quite low for companies serving environmental niches.
Since acquisition activity is a feature of this industry, the number of big waste collection operators in the U.S. (annual revenues above $1 billion) is likely to remain on a decline. Indeed, consolidation has progressed in good economic times and bad. Often, there is a wave of divestitures in the wake of the completion of a sizable deal, which is a benefit to some of the other players, since they may well be able to fit these assets into their operations to gain scale and enhance profitability. Elsewhere, those companies providing specialty waste services will likely continue to utilize acquisitions to broaden their international operations.
The Earnings Predictability score for the large waste collection companies is usually at the top end of our 100-point scale. It is much more varied for the other companies in this industry, and this is a key consideration for most investors. The same is generally true for 3- to 5-year appreciation potential. That is, the stocks of the largest players tend to offer solid, but not outstanding appreciation potential, while a few stocks in the environmental niche group may well reward long-term investors handsomely.
As implied above, large waste collection companies have a relatively high level of depreciation and amortization charges. The result is that cash flow per share is usually much higher than earnings. Accordingly, we suggest that investors examine the price chart on the Value Line page, which depicts the relationship between cash flow per share and a stock's price. In the case of large waste collection companies, a buying opportunity may be at hand when the "cash flow" line is above the current stock price; caution is likely warranted should the reverse case hold true.