The covid pandemic may have curbed industrial waste but households still put their bins out, allowing Australia’s biggest garbo Cleanaway Waste Management to meet guidance expectations.

Morningstar analyst Grant Slade has increased his fair value estimate by 3 per cent for Cleanaway (ASX: CWY) to $1.75 per share to account for the time value of money.

But while Slade is upbeat on the company’s earnings growth prospects, he says shares in the no-moat company continue to screen as expensive, trading at a 43 per cent premium to his valuation.

While Cleanaway is good at collecting waste, disposal—where the real money is made—remains its Achilles heel. And crucially, approval of a new putrescible landfill in the key market of NSW is improbable within the next fifty years, Slade says.

“The market is overlooking the fact Cleanaway doesn't have a significant landfill portfolio like the big players in the US. 

"Cleanaway does have a landfill in Melbourne (which is nearly full) and another in South Australia. So they do have landfill licences. It's just that collection earnings dominate the earnings they derive from the Melbourne and Adelaide landfills. 

"And there’s nothing they can do to get into disposal, which is the cash cow of waste management.”

A contraction in fourth-quarter commercial and industrial waste volumes and weak recycled commodity prices tarnished an otherwise resilient top line for Cleanaway’s solid waste services, or SWS, segment in fiscal 2020.

“As we’d anticipated, the coronavirus pandemic provided minimal challenge to no-moat Cleanaway in the second-half of fiscal 2020,” Slade says.

“While commercial and industrial waste volumes were impacted by reduced economic activity in the fourth quarter, Cleanaway’s significant exposure to the economically insensitive municipal waste stream delivered earnings resilience.”

Group fiscal 2020 pre-tax earnings of $252 million tracked Slade’s full-year estimate of $254 million. Net profit rose 8.7 per cent to $152.9 million, while revenue rose 2.1 per cent to $2.33 billion.

Slade anticipates waste volumes will remain soft in fiscal 2021, with the economic fallout from covid-19 likely to continue weighing on C&I waste generation.

He forecasts fiscal 2021 group EBIT of $264 million, a modest 2.7 per cent increase year on year.

“Nonetheless, with waste volumes likely to normalise from fiscal 2022—as the economic recovery from the pandemic takes hold—we continue to anticipate mid- to high-single-digit operating income growth over the coming decade.”

Cleanaway Waste Management (CWY) - 1YR

Cleanaway (CWY) - 1YR

Source: Morningstar Premium

Cleanaway origins

Cleanaway is Australia’s largest waste, recycling, industrial and liquids service provider with a network of state-of-the-art facilities, transfer stations, engineered landfills, liquid treatment plants and refineries.

It has about 140,000 commercial and industrial customers and about 90 municipal council waste collection contracts.

Initially spun out of Brambles in 1979, Cleanaway has grown to become the 17th largest waste management company in the world following the $671 million acquisition of listed waste specialist rival Tox Free in June 2018.

Solid Waste Services accounts for about 82 per cent of group EBIT. Segment revenue grew 2.2 per cent—excluding the effect of recycled commodity prices—underwhelming relative to our forecast 3.7 per cent growth.

As a result, segment fiscal 2020 EBIT of $213 million was also 3 per cent softer relative to Slade’s estimate.

“We expect volume growth to remain subdued in fiscal 2021 with economically sensitive commercial and industrial volumes likely to weaken. Therefore, we forecast segment EBIT growth of a modest 3 per cent to $219 million.”

Late to the landfill licence party

So why is Cleanaway overvalued? Waste management essentially comprises three components: collection, recycling and disposal. And Cleanaway, unlike the US giants, doesn’t cover the entire spectrum, Slade says.

And for now, this advantage lies with the global “heavy hitters” in waste, the European companies Veolia and Suez.

“The market is assuming Cleanaway has the same competitive attributes—ie a landfill licence —of US wide moat players Waste Management (WM) and Republic Services (RSG).

“Why we see those as wide moat companies and Cleanaway as a no-moat is because of its earnings mix,” Slade says. “WM and Republic own a substantial portfolio of waste disposal assets, ie landfills. Which benefit form NIMBY (not in my backyard) effects, and this gives them pricing power.”

Nor are landfills replicable assets, which means owning them allows waste managers to extract more profits from the entire value chain.

“Cleanaway, however, have been incredibly flat-footed in picking up key disposal assets in the past decade so they remain predominantly a collections business and they’re thus participating in the segment of the value chain where competitive tension is greatest,” Slade says.

Cleanaway has five landfill licences but none in NSW. Veolia and Suez, on the other hand, own Sydney’s two putrescible landfills at Woodlawn and Lucas Heights, in the city’s west and southwest.

Medium uncertainty

Despite its lack of a licence, Cleanaway has a medium uncertainty rating. Slade expects waste volumes in Australia to grow at a compound annual growth rate of 1.1 per cent over the coming decade.

“While waste volumes are relatively insulated from the ebbs and flows of the economic cycle, they are not entirely immune to a downturn in economic activity and we must factor this in order to value Cleanaway on a through-the-cycle basis.

“We factor a global economic downturn of 2 per cent in our 10-year forecast period; we include this in 2025, although we don’t explicitly forecast macroeconomic direction.”

Clean balance sheet

Slade remains comfortable with Cleanaway’s balance sheet amid the covid turbulence. Its liquidity is more than ample to secure the business’s operations without external financing through the medium-term.

“With minimal debt maturities over the fiscal 2021—fiscal 2024 period, Cleanaway’s sources of cash—those being cash at bank, undrawn debt and operating cash flow—are more than sufficient to fund Cleanaway’s ongoing operations over said period.”

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