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  Waste management firm should be left by the curb

BENJ GALLANDER and BEN STADELMANN

Tuesday, February 24, 2009

One of the salient questions of this recession is, How will it impact on the "best and brightest" businesses? Will their growth models hit the wall in a contracting economy, or can they use their strong market positions to become even more dominant over their suffering competitors?

Metrics such as a high rate of return on capital, strong free cash flow, and steady revenue growth, year after year, are the stuff that make little acorns grow into mighty oak trees. By these measures, Calgary-based waste-management firm Newalta is a Canadian success story.

Since 1993 the company has grown annual revenues from $8 million to $500 million, becoming the pre-eminent player in the sector, with a 30 percent market share. It employs more than 2,000 people at more than 80 facilities nationwide.

Treating waste in an environmentally responsible fashion has been a hot topic, and many start-ups have tried to make their mark, but most have struggled to survive. For example, Bennett Environmental has been on our Watch List for years, as we observed it dropping from a high of over $25 to the current 15 cents. Another that never quite tickled our fancy enough to buy is Organic Resource Management, formerly National Challenge Systems, which has plunged from above $8.00 to 45 cents.

Newalta has a record of acquiring the small fry to grow revenues, expand its service offerings and spread out geographically. Another key part of Newalta' strategy has been the accumulation of tax loss pools; many of the firms it acquires have large R&D credits and years of operating losses.

Rapid growth requires capital, and Newalta has been adept at fashioning itself as the "flavour of the day" to attract it. No mere waste disposal service, the enterprise casts itself as an expert in "product recovery." In early 2003 Newalta jumped on the income trust bandwagon, opening at $9.30 a unit with a monthly distribution of 9 cents. Over the next few years it powered forward, raising distributions to 18.5 cents by May 2006, sending the units to a high of $35.

With the trust tax changes looming, Newalta is on the vanguard of re-conversion back to a corporate structure and regular dividends. That took a big bite out of the yield, down to an expected rate of 20 cents per quarter.

According to the management information circular, the conversion would provide investors with an attractive, sustainable dividend yield in a growth-oriented company while delivering strong returns through capital appreciation. As for corporate taxes, no worries there, with $80 million in tax loss carry-forwards and $423 million in tax shelter pools, there' nothing to shell out until 2012 at the earliest. Talk about having your cake and eating it too!

Billionaire Clayton Riddell recently did, picking up an additional half million shares, to pad out the over five million already owned, for a total of 6.3 million shares, comprising 14.9 percent of the total outstanding. But the rest of the market seems much less confident. Despite a reasonably upbeat outlook from management in the third quarter reported last November, investors fret over the heavy debt load of $315 million. Units were sent to a new low of $4.89 last week.

The view from here is that reduced economic activity creates less industrial waste. Therefore, in order to maintain sales in a shrinking market, Newalta will have to aggressively bid for work, which will reduce margins. Low commodity prices mean revenue from product recovery will go down. The high prices paid for the aggressive acquisition strategy suggests that the $168 million in goodwill and intangible assets on the balance sheet could turn into write-downs.

This implies that the proposed annual dividend rate of 80 cents a share, the first payment of which is scheduled to be made March 31, is not just of precarious sustainability, it may very well be a non-starter. Under the present economic circumstances, shelling out that much cash to shareholders seems foolhardy.

Fourth-quarter and year-end results will be coming out shortly. It will be interesting to see if management's view has changed. Our suggested "flavour of the month," a dish of austerity with a hefty side order of debt repayment, might not please their palate.

No doubt, Newalta is now in the value zone of some contrarians. But to get into ours, management will have to show that it can change gears and consolidate their successful past, rather than undoing it.


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