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david milstead

Crude’s remarkable rebound this year has put the Toronto Stock Exchange on the cusp of hitting 14,000. The composite index closed yesterday at its highest level in six months. It’s a rally that’s been fuelled in no small part by oil’s 70 percent surge since its February low. And now Canada’s benchmark stock exchange is sitting on the brink of a threshold it hasn’t seen since last August.

When the news broke that Progressive Waste Solutions Ltd. would hook up with a U.S. garbage company, nearly all the talk was about taxes. Since the combined company would reside in Canada, but take on the name and management of Texas-based Waste Connections Inc., the merger was a classic "inversion" where the savings from escaping the U.S. corporate-tax regime seemed to drive the deal.

Less discussed, however, was what Progressive Waste shareholders, and Canadian investors, would get out of the transaction. As it turns out, the answer is a lot.

Progressive Waste stockholders got to exchange their 100 per cent ownership of an underachieving company for a 30 per cent stake in a top performer. Waste Connections has industry-leading profit margins and cash-flow performance, two things that likely won't change even as it beefs up the results at the legacy Progressive Waste.

More broadly, the deal creates the third-largest waste company in North America, and a giant new Canadian stock that offers investors in industrials something new, as opposed to the same old railways. At a market capitalization of more than $16-billion, it trails only CP and CN and is nearly as large as SNC-Lavalin Group Inc., Ritchie Bros. Auctioneers Inc. and Bombardier combined. It seems a prime candidate for future inclusion in the S&P/TSX 60, since it's already more valuable than half the companies in that index.

So, what's not to like? Nothing, if you're already a shareholder, as the stock hit a 52-week high Thursday. But with the shares now pushing up against analysts' average target price, the investor enthusiasm for Waste Connections may have trashed your upside if you're only now thinking of getting in.

Progressive Waste was, to be polite, a turnaround story that hadn't really started to turn. Analyst Hamzah Mazari of CRT Capital Group LLC notes a series of earnings disappointments owing to higher operating costs for its collection trucks, despite operating one of the younger fleets in the industry, and failures to fully integrate acquired companies. Before the strategic review that led to the sale, Progressive Waste's management laid out a 2019 target for an EBITDA (earnings before interest, taxes, depreciation and amortization) margin of 29 per cent to 30 per cent, and an aspiration to grow the company by 50 per cent in that time. "Most investors," Mr. Mazari writes, "considered [that] unrealistic" given the company's operating issues.

The company's fate could not have been better, say multiple analysts. Bert Powell of BMO Nesbitt Burns Inc. says Progressive Waste and Waste Connections go "together like a left shoe and a right shoe." Except for Texas, the two companies have little geographic overlap. At about $4-billion (U.S.) in revenue, the combined company is still much smaller than Waste Management Inc. (revenue of $13-billion) and Republic Services Inc. ($9-billion), so there were no regulatory issues with the merger.

The initial guidance is for $50-million in cost savings, plus a $35-million reduction in taxes (down from $50-million, thanks to a recent set of rules from the U.S. Treasury Department designed to curb inversions). Bullish analysts, however, think there's a lot more potential. Mr. Powell notes Waste Connection produces more free cash flow per dollar of revenue than the two bigger competitors, and 85 per cent of Progressive Waste's assets are compatible with Waste Connection's business model.

"We believe that with Waste Connection's operational strategy and discipline the Progressive Waste assets can be improved meaningfully beyond the $50-million of annualized [cost] savings contemplated when the deal was announced," he says, pegging an additional $50-million in profit gains. (Analysts Derek Spronck RBC Dominion Securities Inc. and Kevin Chiang, CIBC World Markets Inc. also expect Waste Connections to crush the initial savings estimates.)

There are a couple of keys to Waste Connection's model. One is that the company has avoided the big urban areas favoured by the bigger companies because their dense routes can lead to higher profitability. Of course, competition then cuts into that profitability; in Waste Connection's rural and suburban markets, the company is better able to maintain higher pricing because it's less likely to get into a price war.

Waste Connections prefers owning its own landfill or operating in markets where there are multiple options to dump trash, and the pricing for the service is competitive. It shies away from areas where uncompetitive, expensive landfill choices cut into profit margins.

The end result is industry-leading margins. According to S&P Global Market Intelligence, the company's EBITDA margin was 33 per cent in the last 12 months, compared with margins ranging from 20 per cent to 28 per cent for four other large waste companies, including Progressive Waste (25 per cent).

It seems investors expect Waste Connections to pull off a fruitful integration of Progressive Waste, as the shares have risen 12 per cent just this month. At Friday's close of $73.50 on the New York Stock Exchange, there's little upside to the average analyst target price of $75.05. (Of the 16 analysts providing coverage, 14 have buy recommendations, with one hold and one sell.) The stingy dividend yield of 0.8 per cent, roughly half Progressive Waste's, does little to help total return. And the stock's earnings multiples also handily top peers.

Mr. Chiang of CIBC, who titled a section of his recent report "Don't Fear the Multiple," says Waste Connections deserves its premium multiples, given the earnings boost coming from the Progressive Waste synergies and its history of operational outperfomance. And, he adds, Canadians pay more for quality: His list of Canadian companies that he says are best-in-class in their respective sector typically trade at a higher multiple than their U.S. peers. (Think the two railways, Telus, Rogers, Cineplex and Metro, he says.)

BMO's Mr. Powell says Waste Connections has produced 12 consecutive years of positive shareholder returns, and has increased its dividend for five consecutive years. It leads him to use the same phrase as Mr. Chiang: Waste Connections, he says, should become a "core holding" in Canadians' portfolios.

All the better, it seems, that Progressive Waste has been kicked to the curb.