Exclusive Markets & Economics of Density

Landline telecommunications […] involve significant fixed costs within each regional market, which are a requirement for economies of scale. These economies have created barriers to entry, protecting the incumbents. Potential entrants would have to seize sufficient local market share to become viable competitors, and the incumbents’ existing degree of customer captivity has made this difficult to achieve.

By contrast, global markets for long-distance telecommunications, film production, recorded music, and books are so large that they will support many entrants, each with a relatively limited market share.

– Bruce Greenwald, All Strategy Is Local.

This essay is one of the intermediate level steps to understand the waste industry as outlined in our primer on the waste industry.  Of the many peculiarities in the waste industry, economics of density & exclusive markets are the most important industry dynamics to comprehend for competent analysis of the waste space.

This essay aims to explain the distinction in market types that waste operators participate in. There have been a multitude of studies on “how waste markets function”, but geographical areas differ widely in trash collection. Context is king when it comes to analysis.

Classification: Natural Monopoly

The waste industry is defined as a natural monopoly by the United Nations Environmental committee.  Below is an excerpt from the 19th page of a UN committee discussing the waste industry:

19

Source.

So what is a natural monopoly? A natural monopoly is when economies of density combined with high asset depreciation ensure that full volume with one operator provides the most efficient solution for stakeholders.

Let me unpack that sentence in layman terms:

  • Economics of density is when a business can provide the same services with the resources by having more customers in one specific geography. Imagine that a neighborhood of 5000 people need to employ guards to patrol their street at night to dissuade criminals. Here are two scenarios that illustrate how economics of density work.

    Scenario 1: Each household uses a different residential guard company. In front of each house, a guard is stationed (5000 guards). Criminals are extremely dissuaded.
    Scenario 2: The entire neighborhood employs a single guard company. The guard company sends out 50 people on patrol each night. Criminals are extremely dissuaded.

    Scenario 3: The entire neighborhood employs a single guard company. The guard company sends out 4 people on patrol each night. Criminals are moderately dissuaded.

    Sending out 50 people to patrol a tiny neighborhood is still extremely excessive, but I wanted to emulate the effect of scenario 1 at a 1/100th of the cost. It should be clear when comparing all examples that a single provider uses the least amount of resources to achieve the desired effect.

  • Asset depreciation is when a business needs to replace expensive equipment to continue operating. If you run a personal taxi service (perhaps through Uber) then you need to replace your car every 6 years. So while each tour might only cost new fuel and personal wages, you still need to earn enough excess profit to cover replacements later on. This is why depreciation is listed on the income statement.In very competitive industries companies with large asset depreciation can often be long-term unprofitable as they are forced to sell their services above immediate cost, but below costs when including the need for replacement.

By having these two attributes the waste sector is much more stable and efficient through communal contracts rather than individual use.

As a result natural monopolies often consolidate customers and bid them in contracts, to ensure that a bidder can be insured optimal volume while still promoting price competition through the auction process. 

To provide a concrete example for economics of density in the waste sector: Imagine 6 areas that need trash collection.

20.PNG

Authors creation. Simplified Model, Economics of Density.

If a collection route has to operate above economic cost (including depreciation of trucks) there are two important factors:

1. How many circles you operate in (keeping utilization high on fixed assets)

2. Keeping the length of lines to a minimum (keeping variable costs low)

Below are two images that contrast potential solutions.

21.PNG

Authors creation.

It should be clear why the entire waste industry operates on contracts. This is one reason why waste operators generally consolidate areas over time, and the reason that operators are generally densely focused in terms of geography. Only the big players have nation-wide operations.

There is an important caveat to above model that illustrates the first major industry dynamic. Only certain markets have economics of density. Whether a market benefits from economics of density depends on the volume in each market. 

Volume & Economics of Density Explained

There is only a certain amount of space in a garbage truck. If a truck could be filled from one circle there would be no regional economies of scale.

In Bruce Greenwalds book Competition Demystified he outlines how a supermarket in a rural town will have complete dominance. There is simply not enough demand to sustain two supermarkets, so nobody attempts to enter. However a metropolis will have enough volume to sustain multiple supermarkets who will have to compete on prices.

The same is true in the waste market. De-minimis size requirements make isolated markets attractive. If (in our illustrated example) each circle had enough trash to sustain a whole operation, there would be no economics of density. As such there would be regular price competition.

When operators who focus on exclusive markets, such as Waste Connections (NYSE:WCN), acquire urban contracts the EBITDA-margin is at least 500 basis points lower. 

The team at Waste Connections generally include the following slide in their presentations.

22.PNG
Source: Page 5.

We cover integrated versus non-integrated in our article on: “How Landfills Drive Consolidation”

The table clearly shows that exclusive markets are preferable to competitive markets. As explained above “exclusive markets” simply means that the areas are rural enough that regional economies of scale manifest themselves.

What Does This Mean for Investors & Entrepreneurs?

For investors it is important to recognize that margins are not comparable across companies with different market compositions. In the United States operators such as Waste Connections have margins in vast excess of peers such as Republic Services or Waste Management, but not because the other two have inefficient management. One cannot simply expect margin differences to close or use them as arguments for return to the mean.

Investors should also consider if rural markets will turn urban or enough people will migrate to make rural markets less attractive over time. Investors should keep market-composition in mind when setting margin-targets for companies that haven’t realized full utilization on assets.

For entrepreneurs the exclusive/non-exclusive market paradigm illustrates what both companies and customers are interested in. Waste operators are interested in purchasing solutions that solve volume-issues in urban areas.

Customers, such as municipalities, are interested in making bids competitive in rural areas. The task is vastly more difficult for an innovator here, but could include alternative logistics solutions or software that optimizes consolidation of municipalities for contract-offerings.

Most of all both investors and entrepreneurs need to comprehend what drives profitability and market paradigm for businesses and customers alike.

 

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