MANAGEMENT: Less Waste And More Competition Lowers Ratings

David Davenport and Bill Wolpin

Credit quality for publicly held waste service companies was found to have declined over the last year, according to an analysis from Stan-dard & Poor's (S&P) Environmental Services CreditReview.

Solid waste companies' credit quality, although reported above average for all industrial firms, still experienced a slight decline last year "reflecting more aggressive financial policies of major rated players and less attractive industry fundamentals, which resulted in lower than expected profitability and internally generated cash flow," noted the report. Also, ac-cording to S&P's report, the recession had caused waste volumes to shrink and pricing to become more competitive.

Even with the decline, operating margins and returns on permanent capital of S&P's six core municipal solid waste (MSW) firms surveyed remain strong, averaging close to 30 percent and 15 percent, respectively, said the report.

The analysis found that demand for the residential MSW markets is predictable because of the need for collection and disposal services, while commercial and industrial sectors are more sensitive to economic swings. In the 1980s, economic slowdowns did not affect the industry since it was less mature and grew at a faster pace. In recent years, however, increasing volume, rising prices and acquisitions, which attributed to high revenue growth in the 80s, have flattened or slowed (see chart on page 14).

The report predicted that the factors affecting future industry growth are increased recycling; reduced capacity from regulations; declining landfill disposal; ongoing privatization and consolidation; and higher financial risks.

Recycling growth, one of the most pronounced changes in the industry, has increased to 18 percent from 10 percent of MSW disposal in the last seven years, according to the analysis. Recycling, now an accepted waste disposal alternative, offers solid waste firms opportunities to increase market share. Profitability will improve, according to the report, as markets for paper and paperboard, plastics and other materials expand and prices of recyclables rise. However, the report predicted that profitability still may remain lower than traditional services.

As more stringent rules for location, design, operation and closure are set for landfills, capacity will decline, noted the report. The author predicted that Subtitle D will have a greater impact on local and regional markets as excess ca pacity is reduced or eliminated or costs rise. The Environmental Protection Agency estimates that most of the 5,350 MSW landfills operating in 1992 were not environmentally acceptable. That number could reduce to 3,500 to 4,000 in the next few years as a result of new rules, which could reduce capacity by 10 to 15 percent.

The report also predicted that landfill disposal will decline from the current 67 percent of the volume of the waste stream to 50 percent by 2000 as disposal methods turn more toward reduction, recovery and waste-to-energy.

Privatization and consolidation will continue, although acquisitions will become less critical for expansion as companies grow. The report noted that continued privatization and consolidation are expected to increase market share for the firms.

Favorable business prospects, competitive positions, undervalued assets and predictable cash flow have allowed S&P-rated companies to assume additional risk while maintaining credit quality, said the report. Less attractive industry fundamentals have made aggressive debt use inconsistent with companies' ratings, which led to the downgrading of long-term debt for the two leading publicly held firms. High cash needs for operations and expansion have caused firms to seek outside financing. The report also noted that a larger amount of future financing will be necessary for privatization and consolidation, overseas expansion and sizable capital expenditures.

The report suggested that for firms to grow, they will have to be well-managed, have integrated operations with good regional density, maintain a low cost structure and satisfy a more sophisticated customer. Larger, more financially secure publicly held companies are reportedly more likely to take advantage of industry changes and new opportunities. These companies are expected to become more dominant, further improving their competitive positions.

Standard & Poor's Environmental Services CreditReview also rates 20 companies involved in solid waste collection and disposal, waste-to-energy, hazardous waste management services and other related activities.

For more information on the CreditReview, contact Roman Szu-per, Standard & Poor's Ratings Group, 25 Broadway, New York, N.Y. 10004-1010. (212) 208-8856.