A Technical Primer For The Waste Industry

Garbage Is, always. We will die, civilization will crumble, life as we know it will cease to exist, but trash will endure” – Robin Nagle, Picking Up: On the Streets...

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Photo by Tuesday Temptation from Pexels

The waste industry attempts to earn a profit by removing unwanted side-products from customers. Just as trees produces oxygen as a byproduct so the entire industrial economy produces waste. Government or private industry (most often government AND private industry) have to deal with the disposal of the trash.

A sprawling waste ecosystem emerged as a response to the need for handling garbage properly in the 20th century. The industry was spurred on by regulation across the globe. Every urbanized country in the world has to deal with trash disposal, but each nation has distinct regulation that influences the shape of the waste industry. Laws regarding illegal dumping help landfill volumes, but laws on trash reduction (such as banning straws) hurts landfill volumes. 

The waste industry has a rich and deep history in both the United States and Europe, but the key takeaway is that the waste industry is a byproduct of commercial activity and government regulation. Analyzing waste in any market depends almost entirely on these two factors.

1. The Customers

Waste operators receive trash from a variety of sources and dispose of them. The producers of trash are varied, but in general the production of trash can be tied to commercial activity and consumer spending. The waste industry is, in other words, procyclical. That means that profits in the industry depend on the economic climate. If the economy is chugging along more trash is generated which leads to better conditions for waste companies. 

The customers are varied, but they all produce refuse that they prefer to be handled by outside parties. Below is a very broad categorization of waste industry customers:

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Waste Volume Contributors, Produced by the author.

The above photo describes the volume contributors in the industry. Almost every company produces commercial waste, but the arrows are meant to illustrate the specific outputs associated with producers.

When waste volume numbers are provided on industry conference calls, they simply represent an aggregation of the above triangles. The above graph is an accurate model, but the goal is to illustrate that the entire “unwanted” output of the economy has to be handled. The waste industry fulfills that need.

The two main groups of trash in the US are residential and C&D (construction and demolition).

Residential trash, often called “municipal solid waste/MSW”, is trash generated by regular consumers. Residential waste is a large volume contributor to the overall waste industry. More importantly MSW is often landfilled. MSW is one of the core drivers of landfill volume. Residential trash often contains a large amount of packaging. Seeing as most packaging is designed for advertising, not environmental concerns, a lot of packaging plastics end up landfilled. Residential trash is impacted by discretionary spending in less affluent areas.

Construction & demolition (C&D) trash refers to waste generated from property development and reconstruction. C&D is a huge volume contributor, but a large percentage (+70%) is recycled. This means that overall waste volumes depend heavily on construction and demolition waste, but that C&D plays less of a role for landfills. The material not recycled in construction & demolition must go to landfills with specific regulatory allowances, generally classified as C&D landfills.

Outside the US the importance of waste streams differ widely. Low-income countries have a high degree of organic waste and generally have low recycling rates, while high-income countries use a lot of paper and recycle more. Other differences include plastics, metals, and regulation on disposal. In many low-income countries a large percentage of waste is still ‘dumped’ in non-disposal areas. 

2. Where Does The Trash Go?

There are several avenues of disposal available. Reuse, recycling, and landfill are the ones most commonly mentioned, but transforming the waste into energy by burning it (abbreviated WtE, Waste-To-Energy) is another possibility.

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Waste Industry Disposal Opportunities, Produced by Author.

Reuse is using the existing materials in its current form. Certain types of C&D waste can be scavenged and reused in later projects. Reuse is uncommon for waste operators and not usually associated with scaled commercial activity.

Recycling is the major alternative to landfills. Recycling is defined as taking a material, breaking it down, and using it again. The most advanced vertical in this field is sustainable packaging. Paper is one of the most popular recyclables due to the ease of treatment and active secondary market. When waste operators recycle they earn between 7-20 cents on the dollar in pre-tax profits (EBIT margins), but the activities usually involve little capital investment. This means that waste operators can earn great returns on invested capital, but have a hard time reinvesting money into the business with high returns. Recycling has historically been a volatile field for waste operators as most contracts have been partly based on commodity-prices for recycled goods. 

Waste operators usually derive a material percentage of their free cash flow from Landfills. Landfills are a threatened breed, with material capacity constraints burgeoning in the near future. At the same time the economy and industry is transitioning towards recycling and other disposal methods. Landfills are high in fixed costs, but have great incremental margins (the profit earned on each additional piece of trash landfilled). Not counting the original cost of acquiring the land-plot, Waste Management estimated, in a 2012 investor presentation, that their incremental margins on landfills were in excess of 65%.

Landfills can be inevitable disposal choices as certain materials are simply not economically viable (yet) to recycle. The waste-to-energy process also creates residual products that must be landfilled so a 100% transition to WtE is impossible. It is worth noting that Waste-to-energy can also lead to high-yield metals for recycling. 

In a traditional analysis the disposal methods are the products offered. Customer preferences, complementary products, and margins in the product-offering are extremely diverse.

3. What’s in The Box?

The waste industry takes unwanted trash and disposes of it, but the material must be moved there first.

The waste business is logistics, outsourcing, and “toll-road” economics intertwined. The toll-road economics are present when moving a large supply of trash into a limited supply of disposal opportunities. 

The black-box is the logistics aspect. Collection is a material percentage of sales (+60%) at every waste operator.

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The black box contains many of the primary expenses. There are two primary sources of costs. Employees and trucks.

Trucks use fuel, require insurance, and require maintenance. Across almost every American waste operator I’ve found that roughly 8-9% of sales have to be spent on maintenance. If any waste company is vastly in excess of this figure they are either dramatically under-utilizing assets, taking low revenue contracts, or operate inefficiently in their maintenance programs.

Labor usually amounts to 7-9% of sales, an assorted mix of costs add a few hundred basis points. Administrative expenses such as sales and back-office tasks (SG&A) usually end up between 11-13% of sales, depending on scale and efficiency. The labor market is tight in the waste industry and wage inflation is usually in excess of inflation-indexes. Employee healthcare costs are a material driver of SG&A, as the mortality rate of working in the waste industry is the fifth-highest in the US.

The black box includes sorting stations for recycling, often called “material recovery facilities (MRFs)”, and transfer stations. Material Recovery Facilities sort materials for recycling. Transfer stations move material from heavy-duty refuse trucks to efficient transport vehicles.

The waste operator compensation for all this heavily depends on geography and asset-mix, but below is an indicative EBIT-margin estimate from Bank of America Merrill Lynch. For non-investor readers, EBIT refers to earnings before interest and taxes.

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(Source: Bank of America Merrill Lynch, No time to Waste, 2013)

4. Conclusion

You now have a fairly representative image of the waste industry. Including:

  • Why the industry exists,
  • The two major factors that determine how attractive the industry is,
  • Who generates waste, and which sorts.
  • Where waste is disposed,
  • How it gets there, and
  • The margins associated with each link.

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The Model

Fully understanding the waste industry takes a lot of work, but the primer above should lay a great foundation.

In upcoming essays we will clearly outline a few intermediate level concepts in the waste space, including:

Feedback appreciated at HerskindAgarwal@gmail.com

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:

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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.

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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.

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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.

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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.