Five reasons to buy Transpacific

Transpacific Industries’ share price peaked above $11 in July 2007, 20 years after the company was founded and two years after the stock joined the ASX in May 2005 at $2.40. Founder Terry Peabody’s debt-fuelled acquisition strategy was extremely risky, as we explained in Toss out Transpacific Industries on 4 Jul 06 (Avoid – $6.85), and the share price eventually collapsed to 55 cents in October 2011 following several capital raisings.

Since then Transpacific has had two chief executives, with Kevin Campbell announcing his resignation after just 36 months in the top job in June 2013, to be replaced in October by Bob Boucher (previously executive vice-president of operations for US-listed waste management business Republic Services). The last dividend was paid way back in October 2008.

It’s a cautionary tale on the risks of empire building, but following the recently announced deal to sell its New Zealand waste management business things have changed. Transpacific’s debt levels will plummet and a host of other changes over the past year mean it could soon resume paying dividends. Yet despite the good news the share price has fallen 12% from its recent high of $1.23. While we missed the opportunity to buy at prices well below $1 around a year ago, the company is now a much safer bet.

There are many reasons to buy Transpacific at current prices, but we’ve whittled them down to five.

(1) Dominant, necessary business

Transpacific operates Australia’s dominant waste management business (see charts 1 and 2). Whether it’s your wheelie bins at home, confidential documents at the office or toxic industrial waste, Transpacific will pick it up on time and recycle it, destroy it or process it for landfill. The company also offers a variety of related services, such as emergency clean-up services and consulting to help you reduce your waste and expenses.

The company’s comprehensive network provides a high barrier to entry, as you need to spend hundreds of millions of dollars on a modern fleet of specially designed trucks to navigate difficult and variable urban landscapes in a timely manner.

The industry is also highly regulated and you need a huge customer base to make such a large investment worthwhile. If you’re looking for a business that customers can’t live without, this is it.

(2) High free cash flow

Transpacific’s embarrassing share price performance belies the quality of its Australian waste management business, which is set to shine over the next few years now that the company is shedding the disparate and poor-performing businesses accumulated under Peabody, who sold his 11.3% stake in March last year. 

Over the past year Transpacifc has disposed of 31 of 42 businesses that weren’t contributing to operating earnings (see Chart 2). The Commercial Vehicles division, which sold Western Star, Man and Dennis Eagle trucks, has been sold, and in March the company announced it was selling its New Zealand waste management business for NZ$950m.

These sales foreshadow several things. In a year or two Transpacific’s key profitability measures should look much healthier. Margins should increase (more on that below) and return on assets and return on equity should increasingly reflect the quality of the company’s core waste management business without relying on huge amounts of debt to embellish the numbers.

Return on invested capital is currently just 7%, but return on tangible invested capital is a much more attractive 14%. That’s more indicative of future profitability as goodwill reflects past acquisitions that today’s buyer isn’t paying for. We also note the figure was above 20% prior to the recent round of write-offs and debt repayments, but the key point is that Transpacific is now a much higher quality business.  

Perhaps most importantly, there should be plenty of free cash flow. This will allow the company to increase its sales force to reclaim market share lost by distracted management, and/or to buy new landfills to clip the ticket twice from collection and disposal while avoiding the high fees of rival government-owned sites. It should also be able to resume paying dividends (more on that below) and possibly buy back shares.

Tuck-in acquisitions will also deepen the company's competitive moat by increasing market share and economies of scale. As you can see in Chart 3, the Australian market is more fragmented than the US, which means there are plenty of opportunities to acquire smaller rivals.

Transpacific hasn’t produced any free cash flow since listing, but that’s because of the $2.4bn wasted on acquisitions in 2007. Money spent keeping its fleet on the road (or ‘maintenance capex’) is largely in line with depreciation expenses.

With net debt expected to fall dramatically (see Chart 4) management can finally make sensible long-term decisions without worrying about poor-performing businesses, nervous creditors or whether yet another capital raising will be needed.

(3) Margins can increase

Margins are currently depressed due to several factors. First, poor-performing businesses that have either been sold or are about to be sold are still affecting the financials. When clean accounts are published in 2015 and 2016 you should see higher margins coming through from the highly profitable core business.

Second, Transpacific makes high margins providing emergency support services, but profits are lumpy due to the incidence of emergencies. Lately we've been blessed with relatively few but, on average, we're likely to see more high-margin revenue from this area.

Third, management has increased its targeted cost savings from $30–$40m to $50m. As management has been focused on reducing debt, selling businesses and stemming the bleeding from its scores of poor-performing businesses, we expect chief executive Robert Boucher to increase this figure further as he focuses on the core business. Note that contracts already include provisions for higher fuel prices and labour, so the target should include genuinely sustainable operational cost savings.

Fourth, interest costs will fall dramatically as debt falls. Transpacific has also renegotiated its debt facilities at cheaper rates and intends to redeem its expensive preference shares that pay a 6% margin over the bank bill rate with the proceeds from the sale of the New Zealand business.

(4) Cheap Valuation

Transpacific doesn’t look especially cheap on a forecast 2015 price-earnings ratio of 15. But under new chief executive Bob Boucher, we'd expect profitability and valuations to move closer to those of Waste Management and Republic Services in the US on a higher level of earnings (see Table 1).

It’s also instructive that EnviroWaste – one half of the waste management duopoly in New Zealand – was sold to Asia’s richest man Li Ka-Shing via Cheung Kong Infrastructure at 10 times (depressed) earnings before interest, tax, depreciation and amortisation (EBITDA) last year. Transpacific’s profits aren’t nearly as depressed, but a similar valuation would mean a near-doubling of its share price. It’s not what we expect, but it suggests a large margin of safety.

The main risk is a recession as less economic activity would mean less waste for collection and disposal, despite many regular services struck on 1-5 year contracts (Municipal contacts run for 5-10 years). But given the potential to increase market share, profitability and margins, and the fact that private equity might be running the rule over the company now that its debt levels are about to drop so low, today’s buyer is being sufficiently compensated. A recession would likely entrench Transpacific’s competitive position while giving us an even better buying opportunity.

We note that former white knight, major shareholder and private equity group Warburg Pincus recently sold out, but that gives Boucher the freedom to manage the company as he sees fit and there is still a lot of idle money needing a home. In his latest missive Jeremy Grantham explained why he thinks we’re on the cusp of an unrivalled explosion in merger and acquisition activity.

(5) Resumption of dividends

The final reason to buy Transpacific is that the company could soon resume paying dividends. There’s no guarantee, but in the world of corporate spin, the company's latest announcement that it will 'consider the resumption of dividends in the near term' is reasonably emphatic.

Few Australian boards can resist the pressure to attract new investors to pump up the share price, which inevitably entails paying a dividend, even if only on a small scale. This would signal to investors that the company’s prospects have greatly improved, but it’s not the main reason to invest. In fact we’d be delighted if Boucher preferred to invest any free cash flow in high return tuck-in acquisitions.

Transpacific isn’t in the same class as CSL or ResMed, but neither is it vulnerable to step changes in its industry or the threat of innovative new products that can rapidly take market share, as has happened to former market darling Cochlear. Waste management doesn’t change much over time and, unlike most businesses, it’s not currently threatened by the Internet (watch out for the drones – Ed).

It's always slightly unnerving to be buying stocks just before major results (Transpacific's full-year result is due on 21 Aug), so you might want to stagger your purchases in case a lacklustre result produces a better buying opportunity. But, despite the share price increasing 8% since Opportunity on the scrap heap on 11 Sep 13 (Hold – $1.00), we’re upgrading to BUY.

Note: We're adding 7,000 shares to the model Income Portfolio and 10,000 to the Growth Portfolio at $1.085 per share for a total cost of $7,595 and $10,850, respectively.