The Dirt on Environmental-Services Stocks

S&P says the group's longer-term momentum is improving, and its fundamental outlook is positive. Favorites include Republic Services and Waste Management

While flipping through the rolling 12-month relative strength charts for the nearly 140 subindustry indexes in the Standard & Poor's Composite 1500 index (consisting of the S&P 500, the S&P MidCap 400, and S&P SmallCap 600 indexes), the S&P Environmental & Facilities Services subindustry index chart popped out at me as a long-term turnaround candidate.

During 2007, this subindustry index rose 1.4% vs. a 3.5% advance for the S&P 1500. Year-to-date through Mar. 14, the subindustry index fell 4.8%, while the broader market declined 12.1%. The subindustry's relative strength has improved ever so slightly, placing it among the top 30% of subindustries in the S&P 1500.

Take a look at the accompanying chart of this subindustry index's rolling 12-month price performance compared with that of the S&P 1500. Any point above 100 indicates sector outperformance vs the S&P 1500 over the prior year, while points below 100 show sector underperformance. The red line is a rolling, nine-month moving average, while the two green bands indicate one standard deviation above and below the index's longer-term mean relative strength.

There are seven companies in the S&P Environmental Services subindustry index, five of which are covered analytically by S&P equity analysts. Four stocks in this group carry 4 STARS (buy) rankings: Republic Services (RSG), Stericycle (SRCL), Waste Connections (WCN), and Waste Management (WMI).

Talking Trash

Stewart Scharf, who covers the group for S&P Equity Research, has a positive fundamental outlook for the subindustry. S&P views this group as somewhat defensive against the backdrop of credit market problems, as cash flow is seen as strong and the business tends to be recession-resistant. Scharf expects solid waste volumes to remain subpar during 2008, while real gross domestic product rises only 1.1%. However he believes price hikes should remain the primary driver of growth from ongoing business, well exceeding S&P's forecast for a 2.5% rise in the Consumer Price Index during 2008.

High fuel prices present a challenge to the subindustry. S&P believes crude oil prices will average $91.33 per barrel in 2008 and decline throughout the year. Scharf expects enviromental services firms' surcharges and hedging programs to deal with rising fuel costs to continue when deemed necessary, while new contracts for industry participants include price escalator clauses as well as broad-based price hikes.

Scharf thinks some of the major names in this subindustry are undervalued, despite S&P's projected price-to-earnings ratio for the group of about 16 times 2008 earnings, a modest premium to the multiple for the S&P 1500. In Scharf's view, per share earnings will rise 8% to 10% in 2008 for the subindustry.

Scharf believes the largest North American waste haulers will continue to sacrifice market share and steer away from low-profit volume work in favor of pricing initiatives, divesting low-margin assets and routes. However he thinks leading haulers will try to enhance customer services in order to maintain a high retention rate, while maintaining a positive "churn" rate (the differential between new work and business lost).

S&P sees low- to mid-single-digit organic (from existing business) growth through 2008, while construction and demolition volumes continue to decline due to a soft residential housing market. In S&P's view, waste management companies will continue to focus on controlling vehicle maintenance and medical insurance costs and investing in fleet upgrades and worker safety programs.

Scharf believes most waste companies will continue to generate cash for debt reduction, share buybacks, dividends, and some "tuck-in" acquisitions and asset swaps.

He also sees higher internalization rates (percentage of trash disposed of in company-owned landfills) and improved route density—volume collected along a localized route—aiding operating (EBIDTA) margins. Despite excess landfill capacity (averaging over 20 years), S&P expects major haulers to continue rolling out price hikes at landfills, which tend to have higher margins. Longer term, we see a favorable environmental trend from the conversion of methane gas at landfills into energy.

So there you have it. The group's longer-term momentum is improving, by S&P's analysis, and the group's overall fundamental outlook is positive, indicating that this group should see favorable relative price performance in the period ahead.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the 136 subindustries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (3/14/08)
Agricultural Products Archer-Daniels-Midland ADM 3 $44
Coal & Consumable Fuels Peabody Energy BTU 3 $52
Construction & Engineering Fluor FLR 4 $137
Construction & Farm Machinery Manitowoc MTW 5 $40
Diversified Metals & Mining Freeport-McMoRan Copper FCX 3 $102
Fertilizers & Agr. Chem. Monsanto MON 3 $109
Gold Newmont Mining NEM 3 $54
Industrial Gases Air Products APD 3 $89
Integrated Oil & Gas Exxon Mobil XOM 5 $86
Internet Retail AMZN 3 $68
Oil & Gas Drilling Noble Corp. NE 5 $50
Oil & Gas Equip. & Svcs. Baker Hughes BHI 5 $68
Oil & Gas E&P Swift Energy SFY 5 $46
Steel Carpenter Technology CRS 4 $60

Source: Standard & Poor's Equity Research

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