Environmental Services : UK Waste – An overlooked growth opportunity

The UK waste market is experiencing an important shift away from landfill towards more recycling and recovery. We estimate the country needs GBP10-20bn of investments by 2020 in new treatment capacities, offering a significant but overlooked growth opportunity for environmental services groups. Waste volumes are generally backed by take-or-pay contracts (PFIs) with local authorities, lowering operators’ exposure to the economic cycle. We believe Pennon is the most exposed and best positioned to benefit from this trend.

• Diverting waste volumes away from landfills: The UK waste market is experiencing a fundamental transformation, diverting volumes away from landfill (~50% of current volumes) towards more recycling and recovery. This trend is bolstered by supporting incentives in order to comply with stringent EU targets. The landfill tax which increases by GBP8 pa per landfilled tonne makes other treatment solutions much more attractive.
  
• Significant growth potential in the UK waste market: We assessed the growth potential of the UK waste market and found that GBP10-20bn of investments in new Energy-from-Waste (EfW) treatment capacities are required by 2020 for the country to meet its targets. This represents ~15-30% of total revenues over the period. We think this growth potential will significantly contribute to companies’s P&Ls, but this is being overlooked as yet.
  
• Lowering exposure to the economic cycle: Waste activity is seen as a very cyclical business. The vast majority of new treatment capacities are backed by Private Finance Initiatives (PFIs), which offer stable secured volumes from local authorities thanks to take-or-pay contracts. This looks attractive in the current lacklustre macro environment.
  
• Strong financials on an EfW project-basis...: We look at the financials of a generic EfW project (200k tonnes, 15MW, GBP150m capex). This generates GBP25m+ of EBITDA pa on average over 25 years of operation. We value it at ~GBP0.95m/k tonne and estimate the payback is close to 7-8 years.
  
• ...but different accounting methods at the group level: Pennon and Veolia fully consolidate (in the vast majority of cases) earnings and net debt associated with PFIs, while they are treated as associates by Suez Env. due to the finance project structure, with limited contribution to EBITDA.
  
• Pennon is the best positioned in our coverage: We believe Pennon has the most room for manoeuvre to take advantage of the structural shift thanks to a flexible balance sheet, large pipeline and excellent track record.