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Stock Strategist

Seeking Small-Cap Moats: US Ecology

We continue to be impressed by this wide-moat hazardous-waste management firm.

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In the past few months, we've looked at three small caps--John Bean Technologies, Culp, and Badger Meter--that have potential narrow economic moats. These companies are not currently covered by Morningstar analysts, however, and as such haven't received official Morningstar economic moat ratings, so this month I wanted to profile a small cap that we do cover--indeed, one that has also received an official Morningstar wide economic moat rating.

As I noted in the series' introductory article, smaller companies with durable competitive advantages and long growth runways can make for particularly attractive investments since they have the ability to compound shareholders' capital at high rates over long periods of time. With this in mind, small-cap firms with wide economic moats are definitely worth watching. At Morningstar, we believe wide-moat firms can generate returns on new invested capital in excess of their cost of capital for at least 20 years, providing plenty of time for compounding growth. 

Admittedly, a 20-year forecast of generating economic profits is a bold prediction considering the natural forces of capitalism that seek to erode moats. It's a prediction we don't take lightly, of course, and we look for multiple and defensible economic moat sources before awarding a wide economic moat rating. This rating is rare for large companies, let alone small companies.

Meet a Wide-Moat Small Cap
That's why $750 million wide-moat  US Ecology (ECOL) is a company that you should keep on your radar. The hazardous-waste management firm has impressed us so much, in fact, that we recently upgraded its moat to wide from narrow. 

We believe US Ecology's wide economic moat is derived from three sources: 

  1. Intangible assets: U.S. landfill owners are required to possess regulatory permits that often last more than a decade and have options to renew. This regulatory barrier serves to limit the number of competing disposal sites within a certain radius and provides permitted landfill operators an opportunity to extract economic profits. US Ecology operates four hazardous-waste landfills and one radioactive-waste landfill, three of which carry permits covering 20 or more years. Regulators are also reluctant to approve new greenfield landfills, owing to the common "not in my backyard" attitude from residents, and have tended to favor brownfield expansion of existing landfills, which serves to benefit incumbents like US Ecology.
  2. Efficient scale: Hazardous-waste transportation and disposal is a niche market that is served by a handful of players, including US Ecology,  Waste Management (WM), and  Clean Harbors (CLH). New entrants are dissuaded from entering the market by the high regulatory barriers to entry and the long payback period required to generate suitable returns.
  3. Switching costs: Ultimate environmental remediation liability rests with the waste generator rather than the waste disposal company. As such, waste generators have a vested interest in hiring only proven waste disposal firms with a record of successful remediation projects. By hiring an upstart competitor with no track record, waste generators are taking a large and potentially expensive risk.

In our opinion, all of these factors should allow US Ecology to maintain pricing power and consistently generate returns above its cost of capital.

A Number of Wise Moves
US Ecology management has also made some smart capital-allocation decisions in recent years, which we believe have enhanced the company's economic moat. Notable capital-allocation decisions include the acquisition of Quebec-based Stablex in 2010 and the acquisition of a Michigan-based facility in 2012, which firmly established an eastern presence for the traditionally western-focused company. While these investments depressed returns on invested capital in the short run, they've begun to bear fruit more recently.

ECOL Operating Margin (TTM) Chart

ECOL Operating Margin (TTM) data by YCharts

We look favorably on management teams that are willing to sacrifice short-term performance to drive moat-enhancing, long-term value, as US Ecology has done over the past few years. Indeed, Morningstar industrials analyst Barbara Noverini wrote the following when US Ecology's moat was upgraded to wide in November:

"In our view, augmenting the company’s largely western-based operating footprint with a landfill based in the east has improved US Ecology’s competitive position. Building out its eastern disposal network with the Stablex landfill and Michigan-based transfer station lessens US Ecology’s reliance on low-margin transportation services to capture hazardous-waste volumes originating in the east coast. We believe that over time, this dynamic will lead to higher sustainable treatment and disposal gross margins."

Management has also successfully deleveraged the balance sheet following these acquisitions and is in a very strong financial position to either return cash to shareholders or reinvest further in the business. Future capital allocation plans are a wild card, Noverini noted in her recent review of US Ecology's fourth-quarter and full-year report, as there's potential for the company to chase growth in a market with limited acquisition opportunities.

Valuation
Based on US Ecology's relatively low free cash flow and earnings yields as of Feb. 20, it looks like the market expects continued strength in the coming years.

ECOL Earnings Yield (TTM) Chart

ECOL Earnings Yield (TTM) data by YCharts

Noverini agrees that further growth is likely, stating in her current analyst report:

"As the North American economic environment continues to experience slow but steady improvements in industrial production, we can expect US Ecology to benefit from increased operational leverage as well. Under these assumptions, we expect that the company can reach $283 million in revenue by 2017, with five-year average operating margins of 25.7%. As the company increases its higher-margin disposal revenue over time, we expect ROICs to remain comfortably above our weighted average cost of capital of 9.4%, averaging 20.4% over our five-year forecast period."

That said, her fair value estimate of $35 per share suggests that US Ecology is fairly valued today. Still, US Ecology's wide economic moat and promising growth runway make it a small-cap stock to keep on your watchlist.

Todd Wenning does not own shares in any company mentioned. You can follow him on Twitter at @toddwenning.

Todd Wenning does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.