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Fool On The Hill

Monday, March 8, 1999

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Trash Talk

When pundits observe that "market share is dead," it's important to note that an essential qualifying comment is missing from the statement. That is, massive unconcentrated bids for market share are dead. In many industries, densely packed service areas maximize the use of operating assets. This phenomenon often results in a proliferation of intra-industry "asset swaps" in order for the respective firms to exploit their core territories more effectively.

Today's merger between third ranked trash hauler Allied Waste (NYSE: AW) and second place Browning-Ferris Industries (NYSE: BFI), highlights the value placed on density and integration strategies in the garbage biz. Allied Waste is set to acquire Browning-Ferris for $45 in cash per share, along with the assumption of about $1.8 billion in debt, which puts the entire transaction in the neighborhood of $9.1 billion.

Allied's deal values Browning-Ferris at roughly 7.8 times 1998 earnings before interest, taxes, depreciation and amortization (EBITDA). The convertible preferred shares issued to help broker the deal ($1 billion) will convert to 55.5 million common shares, and can launch Apollo Group and Blackstone -- Allied's two biggest shareholders -- into the position of owning roughly 30% of the combined firm. The firm's debt-to-capital ratio will rise to 85% as a result of the transaction, with cash flow from year one expected to pay that down by 5-6 percentage points (and possibly more than 10% by year two).

After informal talks of a combination fizzled last summer, Allied and Browning-Ferris ended up exchanging some holdings in nine states near the end of the year, with each firm swapping operations that generated roughly $120 million per year in revenues. That little transaction gave each company the necessary insight into each other's operations to realize the potential inherent in a full asset combination (with overlap in 20-25 markets). Now that an actual merger is in the works, here's the Allied Waste perspective on the various synergies possible in the deal:

"Allied Waste expects it will achieve $290 million of synergies and cost savings in the initial 12 months after the close of the transaction (and $360 million total) by reducing corporate overhead costs, and by enhancing operating efficiencies and internalization. In the first year, Allied Waste anticipates that it will sell certain non-strategic businesses and complete required divestitures. The proceeds of these sales are expected to be more than $900 million, which, together with more than $200 million of free cash flow generated by the company's operations, will be used to reduce debt."

To understand these projections, investors need to get knee-deep in the operational muck. The "collection" side of waste operations involves collecting and transporting all the waste, and ultimately bringing it to a "transfer station" or directly to the site of disposal (landfill). Revenues from collection come in the form of fees charged to commercial and residential accounts -- with residential accounts usually involving municipal governments. A portion of the service fee is obtained in advance and recorded as deferred revenue, and the rest is recorded upon completion of the service contract. Fees for both commercial and industrial services are normally based on the type and frequency of service, as well as the volume of the waste collected. Disposal fees, known as "tipping" fees, are based solely on the volume of dreck disposed of at the various landfill sites (contracted or owned).

Now, transfer stations are strategically located sites used to consolidate waste streams and are becoming increasingly important in the overall trash hauling scheme. For the most part, they are used to collect sufficient amounts of waste and bide time while the company negotiates favorable volume disposal rates with landfill operators. Landfills are the primary method of disposal of solid waste in the U.S., and with the EPA's 1991 adoption of new regulations relating to Subtitle D of the Resource Conservation and Recovery Act of 1976, meeting the operational requirements for running them has gotten more difficult. This has fueled the pace of acquisitions in the nineties, as many operators unable to meet the standards have ended up selling out.

Looking at this brief operational breakdown, its easy to see how a firm can benefit from the ability to leverage labor and fuel costs over a densely packed service area, as well as avoiding tipping fees to third party landfill operators. The name of the game is the ability to achieve density through the collection workforce, and maximize volume through the landfills. As it turns out, roughly 40% of the trash that Browning-Ferris collects is deposited at competitors' landfills. Allied has significant disposal assets, with its transfer and disposal operations accounting for about 40% of revenues (as opposed to 14% at Browning).

Allied Waste is now entering the same position that Browning-Ferris moved into after its enormous growth ramp-up through the 1970s and mid-1980s. Allied is moving away from the revenue model of the last three years, where 80% of its top line came directly from acquisitions, and toward one in which about 5% of revenues will come from acquisitions. In an interview with The Wall Street Journal, Allied's CEO Thomas H. VanWeelden observed, "This isn't a business where you need a big thinker... We're not keeping awake thinking about how to beat the Japanese. We get up in the morning and collect the garbage."

With the acquisition plan now in place, the growth story theme of "local execution" comes to the fore rather prominently. It's like starting an entirely new firm, with all the assets having now fallen into place. The company has guided earnings in its first full year of combination (2001) to $1.60 per share, which represents 34% growth off of current year 2000 numbers. With upside possible in the estimated $2.4 billion worth of cash flow and $200 million in free cash flow that Allied hopes to generate in the first year of the real turn of the century, Allied may still hold some value at today's closing price.

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