In mid-April, we researched Cleanaway Waste Management (ASX:CWY) in The Dynamic Investor and took a positive view on the shares. We felt that market concerns around management’s ability to manage labour shortages and rising costs were largely one-off and likely to have a muted impact on CWY’s competitive position. Further, we believed that the market was likely to shift its focus from short-term issues to the potential for margin expansion and attractive project economics from the Waste-to-Energy projects over the medium term.

Since our report, the shares have gained ~8% and the 1-year forward P/E multiple has re-rated. With this in mind, we consider whether current levels still present an entry opportunity.

Overview of Cleanaway Waste Management

Cleanaway Waste Management (CWY) is an Australian-focused industrial, waste, and environmental services company. It operates in three segments: Solid Waste Services, Liquid Waste & Health Services, and Industrial and Waste Services. Solid Waste Services involves the collection, recovery, and disposal of solid waste. Liquid Waste & Health Services involves collection, treatment, processing, refining, recycling and destruction of liquids, hydrocarbons, chemical waste, specialised packaged and hazardous waste and e-waste. It also involves the safe treatment and disposal of health-related waste. Industrial and Waste Services provides a wide variety of services to Infrastructure and Resources markets.

CWY’s revenue base is largely underpinned by long-term contracts across all sectors with a geographically diverse customer base of municipal councils, hospitals, infrastructure, resources, commercial, and industrial customers.

Key Fundamental Drivers

Commodity Prices have Settled

CWY’s revenue is impacted by secondary market commodity pricing across several different markets (i.e cardboard, glass, plastic, recycled oil). Outside of the company’s Hydrocarbon business (recycled oil), the largest commodity exposure is cardboard which is impacted by Old Corrugated Cardboard (OCC) prices. OCC prices in the US collapsed over the course of 2022, falling from ~US150/t to ~US30/t in December. The decline was driven by weak bulk-grade demand, high mill inventories, and market-related downtime at major paper and board mills in the US.

The decline in OCC prices impacts the commodity return that CWY can achieve. For larger customers, CWY “hedges” out this risk through rebate arrangements with customers. However, CWY’s group’s rebate structure results in a delayed adjustment to price movements, as these rebates are paid on a lagging quarterly basis. Around 75% of CWY’s commodity volume is linked to rebates.

An improvement in the OCC margin is expected from 2H23 based on price trends and rebate lag mechanisms. Going forward, the Company expects high European energy prices through calendar year 2022. These led to a ~40% decline in the Asian OCC index to reverse the adverse impact in 2H23, with moderate OCC price recovery expected this calendar year. Notably, key OCC grades have lifted from their end-December price levels but remain below their average 1H23 levels. CWY also reported improving profitability impacts in January 2023.

Labour Availability Challenges Showing Signs of Easing

Since 2H22, labour shortages (and the associated rising costs) have been a key challenge for the Company, with competitors facing similar challenges. Over the course of 1H23, labour availability (i.e. vacancies) declined from 773 as at 30 June 2022 to 701 as at 31 December 2022. Labour availability subsequently declined to 672 as at the time of the 1H23 results release. This trend has resulted in an increase in overtime pay and expensive labour hire. Measures taken to ease the labour bottleneck include outsourcing resource procurement (shortening search time), and new initiatives to train workers and enhance employee retention.

In a trading update issued by the Company earlier this month, CWY management noted the pressure on labour markets has eased and productivity improvements are planned. In turn, this is expected to lead to meaningful margin recovery potential, aided by non-recurrence of various operational disruptions and the unwinding of excess costs. Further, the Company is passing on inflationary increases in its costs base through increased pricing. To date, this has not resulted in meaningful changes in competition or contract churn as a result of challenges around labour availability.

Margin Recovery Remains on Track

Despite the current challenges around labour availability, there is scope for strong margin recovery at a group level into FY24/25. Aside from easing pressures from commodity prices, the potential for margin expansion is underpinned by synergies from recent acquisitions and continued benefits from ‘Operational Excellence’ initiatives announced in late November 2022 as part of the Blueprint 2030 strategy.

Waste-To-Energy Strategy Progressing Well

The largest investment opportunities CWY is considering within its Blueprint 2030 strategies are its projects in Wollert (Victoria) and a recently-acquired site in Bromelton (Queensland), which is located to the west of the Gold Coast in an industrial area with good corridors to the Brisbane and Gold Coast markets. The Victorian site (Wollert) requires three approvals to proceed (environmental, development, cap allocation).

The Company expects a final investment decision on its Victorian project may occur in calendar year 2024, with the Queensland project lagging Victoria by around six months. The funding decision has not yet been made, but CWY continues to reference significant lender appetite for the projects, given the infrastructure-like nature of these projects. To this end, a meaningful capital raising may be required if CWY continues to retain 100% project ownership.

In terms of the attractiveness of the project economics, it is worth noting that cost inflation and higher interest rates are headwinds, offset by higher wholesale electricity prices and CPI+ landfill levy increases in Victoria and Queensland.

Strong Balance Sheet to Support Growth Plans

CWY’s gearing level is now below the target range of 2.0-2.5x and the covenant limits of less than 3.0x. There is also sufficient balance sheet capacity that can be used to fund further acquisitions. However, the business will become more capital intensive over the medium term as the Waste-to-Energy strategy (‘Blueprint 2030’) takes shape and as the recently-announced $100m CAPEX program over FY23-26.

Fundamental View

Despite the re-rating in the 1-year forward P/E multiple since our report in The Dynamic Investor, from ~28x to ~31x at present, the multiple remains within the trading range over the last three years. Accordingly, we consider that CWY is still worth considering as an investment, as the market is likely to increasingly shift its focus away from (easing) short-term pressures, towards the potential for margin expansion and attractive project economics from the Waste-to-Energy projects over the medium term.

Charting View

From early 2020 until mid-2022, CWY was in an uptrend. It broke down from that last year before spending the back half of 2022 trading sideways in tightening range. Then in March this year, it broke to the downside. CWY has tried to recover and it is now retesting ght underneath of the prior range. If it can get back above the lower blue diagonal line, then we can be confident that it will start trending higher gain. For the moment though, it appears as though risk is still to the downside and picking up CWY at cheaper levels are a possibility.

 

Michael Gable is managing director of Fairmont Equities.

 

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