Scotia Capital Scotia Capital analyst Konark Gupta is taking a “favourable” long-term view of the North American environmental services sector, citing “its proven ability to consistently price above cost inflation due to high market concentration, ongoing momentum in merger and acquisition (M&A) activity supported by solid free cash flow (FCF) generation, potential for volume rebound as industrial activity recovers, upcoming margin accretion from sustainability investments, and strong capital discipline that rewards shareholders.”
In a research report released Friday titled The Environment Is Right For Processing Sustainable Long-Term Profits, he initiated coverage of five companies in the sector, seeing the potential for “significant value creation.”
“Waste companies have outperformed benchmarks over the long term, driven by their ability to compound earnings and deploy FCF toward inorganic growth and shareholder returns,” he said. “While valuation multiples are rich today, we see potential for more value creation over time as pricing discipline remains strong, price/cost spread is sustained, volumes are due for a rebound, sustainability investments generate higher-margin returns, automation and energy transition improve efficiencies, and solid FCF generation drives more deleveraging, M&A, and shareholder returns. Based on our forecasts for 2024-2026, we see all five environmental services stocks potentially generating double-digit returns over the next two years, led by SES and GFL, followed by WCN, RSG, and WM.”
Mr. Gupta warned of its high concentration and barriers to entry but also touted “predictable earnings and cash flows with annuity-type revenues due to multi-year contracts that have a significant portion of pricing linked to cost indices.”
“While we have a positive thesis on the sector, we are also mindful of some key risks, including the potential for compression in valuation multiples given they are rich in a historical context, increasing commodity exposures from sustainability projects, and the potential for normalization in price/cost spreads,” he said. “Thus, we have a greater preference for our top picks, GFL and SES, which we think offer stronger value creation potential over the next few years, driven by either re-rating, strategic actions, or shareholder returns. GFL not only has an attractive valuation compared to its larger peers, but it also offers more upside from potential M&A and FCF acceleration, aided by ongoing deleveraging toward an investment grade rating. Similarly, we think SES’s valuation could re-rate higher, as investors understand its recent transition to waste management from energy services. SES also offers M&A potential, but we think it is more likely to pursue buybacks in the near term due to its attractive valuation.
“We also like various attributes of the larger waste management companies, RSG, WCN, and WM, although we are taking a neutral view on them due to either expensive valuations, the lack of a differentiated positive catalyst, or company-specific risks (e.g., WM’s pending Stericycle acquisition). However, we expect these larger players to continue to create value for shareholders through their organic and inorganic initiatives.”
Mr. Gupta initiated coverage of these stocks:
* GFL Environmental Inc. with a “sector outperform” rating and US$50 target. The average on the Street is US$46.09.
* Republic Services Inc. with a “sector perform” rating and US$224 target. Average: US$216.55.
* Secure Energy Services Inc. (SES-T) with a “sector outperform” rating and $16 target. Average: $14.41.
* Waste Connections Inc. with a “sector perform” rating and US$196 target. Average: US$197.52.
* Waste Management Inc. with a “sector perform” rating and US$220 target. Average: US$225.85.
Mr. Gupta added: “Valuations are rich but opportunities exist. EV/EBITDA multiples have expanded since the 2007-2009 global financial crisis (GFC), driven largely by price-led margin expansion, increasing FCF generation, and industry consolidation. Consequently, FCF yields have compressed, further affected by the recent rise in interest rates and increased capital intensity (due to sustainability investments), pushing the spread between FCF yield and U.S. 10-year bond yield to negative lately. While we expect a decline in the U.S. 10-year yield to benefit FCF-generating waste stocks, we don’t see a significant upside risk in EV/EBITDA multiples, particularly for the larger companies – RSG, WCN, and WM. However, we believe GFL and SES have the most potential to re-rate higher, which, along with their organic and inorganic growth, could drive share price outperformance. GFL’s re-rating is likely more dependent on potential asset sales, deleveraging, and investment-grade rating as compared to organic and inorganic growth. SES’s valuation has a lot more upside risk, in our view, but it could take longer to narrow the gap to the Big 4 given its focus on the niche end-markets.”