Without wishing to overdose on themes linked to the European Union (EU), one of the criticisms regularly levelled at Brussels centres on the costs to business from what critics have described as an "avalanche of red tape". The claim was rarely disputed, played well with the crowd, and might tap into some latent antipathy towards central authority, but it disguises the fact that strong regulatory regimes actually serve some industries rather well.
The circular economy
Take waste management. A study published by the Department for Environment, Food & Rural Affairs (Defra) reveals that this segment of the economy generates an estimated £6.8bn in gross value and supports 103,000 jobs in the UK alone. And where there's muck there's brass; the study also outlines the growing economic benefits linked to increased resource efficiency. Ever more value is accruing from the extraction and processing of waste materials as municipalities and private industry benefit from co-ordinated waste and recycling policies - the so-called "circular economy". Indeed, last December, the EU published the Circular Economy Package, outlining a range of waste and recycling laws that will be backed by tougher European Commission enforcement than seen under previous administrations.
It goes on to say that the UK waste industry now generates more value than comparable extractive industries, adding around £41 in gross value for each tonne of waste treated (by contrast, a gold miner could expect to pocket $57.60 for every tonne of ore processed, assuming a 75 per cent recovery rate, an average grade of 1.2 grams per tonne and a $1,500 gold price). Extraction rates vary considerably throughout Europe, but the potential offset gains are easily appreciated when you consider that the continent accounts for 3bn tonnes of waste each year. Of that figure, 100m tonnes are classified as hazardous waste, the processing of which commands premium rates.
Compliance-led growth
Beefed-up environmental legislation has proved to be a catalyst not only for growth in the industry, but also for increased specialisation. That specialisation extends to the treatment of hazardous waste materials, ranging from asbestos to agricultural slurry. It's somewhat disconcerting to reflect on the slapdash methods previously employed by industry and local authorities to deal with all manner of hazardous waste materials, but now the industry is shaped and driven by legislation which generally commands widespread public support.
That certainly applies to the sustained and multi-faceted legislative campaign undertaken by the EU and various municipal bodies that has effectively neutered the once dominant position of landfill within the waste management industry in Western Europe (it now seems rather curious that the way we dealt with our waste products had failed to evolve beyond the method employed by the average domestic cat). Despite last month's referendum vote, we don't expect the current regulatory framework to be dismantled whatever political settlement follows.
And it's worth noting that there is considerable scope for growth in the EU's newer member states through what are known as extended producer responsibility (EPR) schemes. EU funds are allocated 'ex-ante', thereby providing capital in advance of the anticipated development of modern waste and recycling infrastructure. New member states are initially given dispensation with regard to environmental directives as they develop systems and facilities to deal with co-ordinated policies.
The public/private split
So what does the industry look like and who are the main players? At the moment, there is roughly an even split between private and public operators in municipal waste collection. Although the incidence of subcontracting by public waste management authorities is on the rise, the aforementioned study highlights "a significant remutualisation of services" as a risk factor for private companies. However, we still believe that the long-term structural growth drivers still outweigh any potential risks. Regardless of regional political pressure to bring waste services back within the public sphere, decisions at the local level are increasingly predicated on cost/benefit analysis, which tends to favour the private sector.
Options in a fragmented market
Despite a step-up in M&A activity through 2014, big-ticket deals have been thin on the ground over the past five years as larger industry players have become reluctant to consolidate 'traditional' waste management services, or at least those that don't incorporate a 'value added' proposition. Instead, the focus has been on strategic acquisitions that meet the needs of a changing industry. Grant Thornton's latest review of the sector shows that recycling M&A continues to see the most investment, with 39 per cent of the deal total. Again, this reflects the rise of the circular economy. It's worth noting that London-listed Shanks (SKS) swung into the black at the operating level at its March year-end, and then promptly requested that its shares be suspended as it was mulling over a potential reverse takeover of Van Gansewinkel Groep BV, a waste management rival operating in the Netherlands and Belgium.
While there has also been increased interest from both private equity and venture capital investors, it remains a relatively fragmented industry. In terms of sheer scale, France's Veolia (FR:VIE) and Suez Environnement (SEV:FP) lead the way, although Germany's family-owned Remondis also generates hefty revenues. Unfortunately, there are limited opportunities for investors to exploit the growth of the sector as many of the largest players in the European market are private concerns.
However, there could be another option in the pipeline. Most city dwellers in the UK would be familiar with the distinctive blood-red livery of Biffa, an integrated waste management group that controls the largest volume of waste domestically. Press speculation has mounted that Biffa, which was effectively acquired by senior lenders in 2012 following financial problems, was recycling plans for a potential £1bn stock market flotation, although probably not until early 2017 at the earliest. Investors will also probably be familiar with Viridor (from the Latin 'to become green'), a recycling and renewable energy specialist owned by FTSE 250 water utility Pennon (PNN). Viridor has been proactive in adjusting its business activities to meet the evolving legislative regime. It has ramped up operations at its energy recovery facilities, nearly doubling total inputs, which has helped to offset the continuing decline in landfill.
IC VIEW:
Around half of the UK's recycling and waste collection is still under state control, but that is expected to change in coming years as part of the government's austerity-led outsourcing and privatisation drive. Overall, however, increased regulatory strictures, combined with the rising importance of secondary raw material markets, are driving the waste management industry forward. The businesses that will thrive in the new environment will either be of sufficient scale, or nimble enough to revert to the use of innovative technologies, energy generation and high-end processing facilities. The ones that are struggling tend to be in the mid-market, where business models are more likely to be based on the traditional model of collection services. In short: garbage is out - waste management is in.
Favourites: The IC believes that operators such as Augean (AUG), which specialises in waste management solutions for some of the more challenging segments of the waste market, such as incinerator ash management and low-level radioactive waste disposal, are well placed to benefit from compliance-led activity in the UK and elsewhere. Augean had a good year in 2015, with double-digit growth in sales, reported profits and earnings, but is still attractively priced as worries over the impact of updated tax guidance on landfill volumes have weighed on the share price - we think those worries have been overdone.
Outsiders: Veolia was one of the IC's Tips of the Year for 2015, delivering a 49 per cent share price return when we closed out the tip at the tail-end of last year. Currently capitalised at €10.8bn (£9.2bn) on the Paris Bourse, it's a true industry leviathan, operating in around 50 countries across the globe through three main service and utility areas: water, waste management and energy services. The group's share price has pulled back markedly since December, partly due to concerns over elevated levels of gearing and dividend cover. As a consequence, Veolia's historic premium to peers has fallen from 33 per cent to 5 per cent. It's too early to call a 'value buy', though.
