Updated Thoughts on the Waste Connections/Progressive Merger

It’s been a busy few weeks for the proposed Waste Connections/Progressive Waste Solutions inversion.

Progressive Waste Solutions (BIN) filed an F-4 statement with the Securities and Exchange Commission (SEC) early in March, which was then amended on April 1. The F-4 document is essentially a preliminary proxy document informing shareholders about various aspects of the pending Waste Connections (WCN)/BIN merger.

Then this week, the U.S. Treasury Department proposed new and tougher tax rules on corporate inversions. In response, WCN and BIN issued a joint statement that, based on their initial review, the companies believe that the proposed regulations could have an impact of less than 3 percent of the combined company’s expected first year adjusted free cash flow, estimated at more than $625 million, and that the two companies remain committed to the strategic merger.

Here are some thoughts based on a review of the F-4 filing.

Merger Timing Unchanged

The document constitutes both a proxy statement of WCN and a prospectus of BIN. Another filing will be forthcoming with voting instructions and definitive deadlines, and the likely timeframe for the merger to be completed remains the second quarter of 2016.

The probability of timely completion has increased as the parties already received Hart-Scott-Rodino (HSR) antitrust approval on February 26, and under the terms of the agreement, both parties have agreed not to solicit third party acquisition proposals. Although the acquisition price had widely been perceived as a very reasonable valuation, the solicitation prohibition, combined with Republic Services’ (RSG) apparent inability to do the same type of deal structure, make a competing offer highly unlikely.

Additionally, the penalties involved in the event the merger is not consummated are not insignificant. The termination fee for WCN is up to $150 million; for BIN, it is up to $105 million.

Background and Rationale for Merger

According to the document, WCN’s and BIN’s senior management had discussed a possible transaction periodically since July 2013. However, the impetus for the announced transaction stemmed from BIN’s board of directors’ November 2015 decision to hire J.P. Morgan in connection with a review of BIN’s strategic alternatives. J.P. Morgan contacted WCN’s senior management about acquiring BIN.

By late November, WCN had retained Morgan Stanley (MS) as its lead financial advisor and engaged legal counsel in connection with a potential transaction, and WCN entered into a confidentiality agreement with BIN on December 2. By the December 18^th deadline, WCN submitted a proposal to acquire BIN, and the proposal indicated that WCN saw potential benefit to domiciling the combined company in Canada.

From that point through mid-January of 2016, all the involved parties negotiated the merger agreement, including price and transaction structure, among other items, with WCN raising its initial purchase price and agreeing to domicile the combined company in Canada. On January 18^th, WCN received a fairness opinion from MS, and the BIN board unanimously approved the merger agreement that evening.

The document enumerated a number of strategic and financial benefits of the merger for both companies. From WCN’s point of view, key considerations were an enhanced earnings profile from sustainable cost synergies and its ability to improve certain cost and financial metrics, as well as the expected credit profile and the expectation of a lower effective tax rate.

For BIN’s board, key considerations appeared to be greater scale and the belief that the combination would increase BIN’s EBITDA to free cash flow conversion, in part due to anticipated SG&A savings but also due to the opportunity to reduce capital expenditures. Once again, the combined company’s potential to achieve annual tax savings was also noted.

Potential Risks Hold No Surprises

The risk factors detailed in the document appear fairly standard overall for this type of merger. Business uncertainty while the merger is pending, management distraction and the accuracy of financial projections were cited.

With regard to the combined company, various (but again fairly typical) integration risks were detailed, including the ability to obtain the anticipated synergies, which is obviously the linchpin of the transaction. Interestingly, currency risk was not highlighted, though it has been a depressant on BIN’s recent earnings results. That said, information on currency exchange rate data in the F-4 show decreasing volatility in the last six months after substantial change in 2014 and 2015. A change in the tax law was noted as a risk, however.

Highlights from the Financial Projections

The combined company is anticipated to have over $4 billion in sales, and WCN had put combined year 1 adjusted EBITDA and free cash flow generation at $1.25 billion to $1.3 billion and $625+ million, respectively, in its various presentations.

Five year forecasts for WCN and BIN were also presented on a standalone basis in the F-4. For 2016, WCN pegged revenues and adjusted EBITDA at $2.27 billion and $769 million, respectively, implying an EBITDA margin of just under 34 percent. The top line growth (including acquisitions) imbedded in the five year forecast averaged just over 7 percent per year, with revenues reaching $3 billion in 2020. The implied margin in the 2020 EBITDA was just under 35 percent, while capex as a percent of revenues was anticipated to remain around 10 percent in 2020, similar to 2016 levels.

In 2016, BIN’s revenue and adjusted EBITDA were forecast at $1.96 billion and $490 million, respectively, modestly below (at least in the case of the forecasted EBITDA) analysts’ consensus expectation, though it should be noted that the consensus masks a wide range. The annual topline growth in the five year forecast is 3% (not including acquisitions). The estimated EBITDA margin in 2020 is just over 26 percent (below BIN management’s five year plan target) versus 25 percent anticipated in 2016. Capex as a percent of revenue was forecast at 11percent in 2020, the same level as 2016.

Valuation Analysis Underlying the Fairness Opinion

Morgan Stanley (MS) delivered its fairness opinion on the transaction price to WCN’s board based on a variety of valuation parameters. Of particular note were historical multiples, comparable companies and precedent transactions analysis.

Based on historical trading ranges, MS selected a reference multiple range of 8x-9x EBITDA for BIN, which, based on the 2016 proxy projections, indicated a range of $22.30 to $26.70 per share, versus the implied deal price at the time of the transaction announcement of $24.55. MS then selected RSG and Waste Management (WM) as comparable companies, and based on their valuations, selected a representative multiple range of 8.5x to 9.0x, which implied equity values of $24.50 to $26.70 per share for BIN.

MS also reviewed six precedent transactions since December 2007—WM/Deffenbaugh Disposal, Advanced Disposal Services/Veolia ES Solid Waste, the two Macquarie transactions, IESI-BFC/Waste Services and RSG/Allied Waste Industries. Using a representative range of 7.5x to 8.5x last twelve months EBITDA and applying it to BIN’s adjusted 2015 EBITDA, MS arrived at a price for BIN of $19.40 to $23.80 per share without synergies and $22.80 to $27.60 per share with estimated synergies of $50 million.

Subsequent Share Price Action Very Positive

Shareholders have signaled their reaction to the merger by bidding both stocks up substantially since the announcement. Even after a negative reaction to the proposed tax regulations, BIN shares are currently trading around $30 per share versus $23.51 on January 15, while WCN now trades around $63 per share versus $51 on January 15.