This is a brief text on a stock I find interesting based on my interpretation of the information I’ve gathered. It’s not advice. It’s probably sprinkled with at least some of my own misconceptions and/or logical missteps, so please read critically and always feel free (or forced) to correct me. Even worse, any logical missteps are likely to be amplified by my heavy use of “back of the envelope”-maths. If you have questions, comments, or knowledge about the industry or company that you wish to share, please send me an e-mail: hariseldomright@gmail.com.
As of this writing, I have a small position (~10% of my portfolio) in Krynicki Recykling (WSE: KRC). My shares were bought at prices between 18-20 PLN. I may decide to buy or sell any amount, at any point, at any price, and for any reason.
Content
Elevator pitch | Background | The company | Economics, levers, and valuation
Elevator pitch
Krynicki Recykling (WSE: KRC) is Poland’s market-leading glass recycler, in terms of scale as well as technology. Its founder and CEO, Adam Krynicki, has significant skin in the game and owns 1/3 of the company.
Poland’s recycling trends and remaining gap to EU-wide targets imply a decade of improved economics for the glass recycling sector. As the dominant niche leader, KRC should benefit greatly.
With a 390mPLN EV (9xEBIT) and a 9% dividend yield, the current price — attractive for the current state of the business alone — seems too low when considering the company’s competitive advantages and ESG-driven growth ahead.
Background — The value proposition, macro backdrop, and competitive landscape
A glass recycler acquires glass cullet from municipal recycling programs (raw cullet). The raw cullet is sorted and processed into clean glass cullet (clean cullet) in a processing plant. The clean cullet is then sold to glass container manufacturers as a raw material.
Value proposition and macro backdrop
The value proposition of a glass recycler is quite unique, as there’s one value proposition to the supply side (i.e. the waste producers; the recycler provides them with waste disposal) as well as one value proposition to the demand side (i.e. the glass container manufacturers; the recycler provides them with raw material). First, let’s view it from the supply side (the society and municipalities).
If you read Jeremy Raper’s write-up on Mo-BRUK, you know about Poland’s landfill problem. In Poland, 42% of waste goes to landfills, vs. 20% in the EU, and 0% in Sweden. New regulations imply that Poland needs to drop landfill use to 10% in the coming years. Previously, Poland’s most used weapon against landfills was to simply make it expensive. The fees for landfill waste disposals (Marshal fee) were raised by large amounts every year. This led to great economics for incinerators such as Mo-BRUK. However, the fee increases have slowed down as Poland has shifted focus to instead increase recycling. Non-recycled glass makes up 10% of landfills in Poland. Today, Poland recycles 57% of used glass, vs. 74% in the EU, and 99% in Sweden. However, the trend is on the right path. In Gdansk, the amount of recycled glass per capita has increased from 11.8kg (2017) to 26kg (2020). In 2019, Polish glass cullet demand was more than double the supply. Thus, the bottleneck for the recyclers’ growth is not on the demand side. It’s on the supply side. I believe that the secular trends driven by consumer behavior shifts and regulators’ pressure will remove that bottleneck, leading to a major growth unlock for Polish glass recyclers. Dare I even speculate that regulators’ incentives to shift glass from landfills to recyclers might, at some point in the future, provide these companies with negative COGS?
Secondly, let’s view the value proposition to the demand side (i.e. the glass container manufacturers). The primary raw ingredient to make glass containers is silicate sand. Crushed recycled glass cullet can replace some of that sand. The rationale for glass manufacturers to replace some (or most) of the sand with clean cullet is multifold:
Resource savings: 1 ton of glass cullet used in the manufacturing means 1.23 tons less of other materials (sand, soda, and lime flour) need to be used.
Energy savings: For every 10% glass cullet used, the glass manufacturing process directly saves 2-3% energy due to the lower temperatures required.
Furnace durability: The lower temperatures required when using glass cullet also increase the furnaces’ lifetimes and decrease service costs.
Regulatory pressure: The EU targets aim at raising the amount of glass cullet used in glass manufacturing from today’s ~30% to 90% by 2030, and increased regulatory pressure on manufacturers seems likely
It’s interesting to note that, despite the apparent economical and environmental advantages of glass cullet, the price of clean cullet is lower than sand, when purchased as an ingredient for glass container manufacturing. I would expect this dynamic to change over the coming years as ESG and circular economy benefits of glass cullet over sand gain increased focus.
To summarize my view on the macro backdrop for Polish glass recyclers, I believe highly beneficial tailwinds appear on both the supply-side as well as the demand-side. Consumer behavior shift and regulatory pressure on municipalities to improve the proportion of glass captured in recycling programs should lead to greater access to raw cullet. Simultaneously, glass producers are pushed to increase the proportion of recycled glass used in manufacturing, which should increase clean cullet demand.
Competitive landscape
Supplying raw materials to glass container manufacturers did initially strike me as a real bottom-feeder-type commodity business, prone to price-pressing competition. A little research changed my mind. In my view, a dominant glass recycler has good protection against competition and ROIC-erosion due to “efficient scale”-type moats, regulation, and their technological advantage and product quality.
“Efficient scale”-type moats
Morningstar’s Why Moats Matter describes the “efficient scale”-category of moats:
Efficient scale describes a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital.
Recyclers’ plants need to be fed with raw cullet from nearby municipalities. Splitting that supply between multiple recyclers would result in bad economics for all parties, providing disincentives, if not barriers, to entry. The low [price/weight]-ratio of raw cullet (basically $0/tonne) and even clean cullet (<$100/tonne) should add protection against international pricing competition. KRC is the dominant player in this industry in Poland today, with one competitor of note in Remondis. Poland’s largest waste management company, Mo-BRUK, has stated on investor calls that it has no plans to enter the glass recycling industry.
Regulation
To open a glass recycling plant is cumbersome and filled with regulatory hurdles. In addition to environmental permits, approvals from local councils are needed. The process to gain approvals often takes >3 years, and that’s before construction can even begin. For a new entrant to commit to such an administrative risk and then commit significant capital expenditures should add further disincentives to entry.
Technological advantage and product quality
Lastly, I’ll push back on the notion that clean cullet is a commodity. Impurities in the cullet that do not melt in the furnaces (e.g. stones and ceramics) can create defects in the containers and/or hurt the equipment. A Rekopol representative:
The quality parameters of the smelter are so high that a stone with a diameter of less than 1 cm or a half of an aluminum ring (like the cap) in the control sample causes the entire cullet delivery to be rejected (25 tons of cullet).
The increasing use of transparent ceramics, and consumers’ frequent mistake to dispose of these as glass, lead to difficulties for recyclers to guarantee purity. KRC is a technological leader in this area, with significant R&D efforts (often sponsored by EU) to optimize the removal of glass-ceramics. Catching up to the technological level of KRC (and the only other real competitor, Remondis) is likely a hurdle for new entrants.
Economics, levers, and valuation
KRC experienced a dramatic increase in profitability in 2021. In one year, the return on equity jumped from a mediocre baseline of around 10% to close to 30%.
In the age of “COVID-winners”, it’s easy to dismiss these patterns as pull-forward effects or temporarily favorable unit prices due to the pandemic. In KRC, I believe that neither is the case.
In 2021H1, KRC provided glass manufacturers with 192’000 tons of clean cullet, for which it collected 61mPLN in revenues. This boils down to 318 PLN/ton of clean cullet. The price per ton of clean cullet has risen steadily roughly in line with inflation over the past decade, with the past 3 years showing slightly faster price increases. KRC’s cullet volume growth had come along at a modest speed, consistent with the past decade. In 2020, the start of the pandemic even caused volumes to drop. The improved profitability appears to not have been a temporary effect of the pandemic.
Rather, the improved profitability is likely due to the company’s claimed significant operational improvements, most significantly cheaper sourcing of greater quality cullet, as well as the acquisition of foreign clients for the purchase of a subtype of clean cullet that had been previously hard to sell domestically. The explanation for the profitability improvement becomes apparent when visualizing the vastly improved unit economics of each ton of glass cullet. This was driven primarily by reduced cost per ton produced.
With the macro backdrop in mind, it appears that the same trends that enabled the cheaper sourcing of high-quality raw cullet (greater availability due to consumer behavior and improved municipal recycling programs) are not temporary. They are secular. Consider the levers determining the profitability of KRC:
The price of clean cullet. Regulatory pressure, as well as economic and environmental advantages of cullet over sand, seems likely to increase the price faster going forward
Cullet volume and plant capacity utilization. Regulatory pressure, as well as shifts in consumer behavior and improved recycling programs, seem likely to increase the volumes of raw cullet available to KRC, thus increasing plant capacity utilization (and thus returns on capital) going forward
Cost to acquire raw cullet. The same drivers as above make it reasonable to believe that KRC will be able to source raw cullet even cheaper going forward
Cost of processing cullet. Although energy prices are an important cost of production for KRC, and one of few “levers” that appears to be going in the wrong direction at present, this should be counteracted by improved scale economics and continued operational improvements
Overall, the image that emerges is a company that is
already highly profitable, and seeing beneficial secular tailwinds across almost all its levers of profitability
leading its niche in terms of technology and scale, in a sector destined for long-term ESG-tailwinds
playing a central role in solving Poland’s waste problem
led by a founder with significant skin in the game (owns 1/3 of shares)
As I don’t like to make predictions (I know, I know… the real Hari Seldon turns in his grave), I have a disdain for DCFs, and unfortunately, I know of no solid peers to benchmark a valuation against. However, it appears to me that KRC should deserve a premium valuation and represents a low-risk asset with long tails deserving of low cap rates. What the right valuation should be, I don’t know. But the current valuation (9 x EBIT, 9% dividend yield) does strike me as way too cheap.
Risks - A Q4 miss is likely
As the market tends to be shortsighted, I would regret if I didn’t mention that I expect that Q4 will be an unusually weak quarter. For one, energy is a significant cost of production for KRC, and as you all know, energy prices in Europe in the past quarter have been unusually high. This should have a negative effect on KRC’s margins. Furthermore, the company will need to shift production from its plant in Lubliniec (due to a failure to obtain regulatory approval to increase capacity - regulatory moats work both ways). The company’s overall production is well below its full capacity, and KRC should be able to counteract this by shifting production to its other plants. However, this will likely entail increased transportation costs and also have a negative impact on margins in Q4. If the market punishes KRC heavily for a Q4 miss, I lean towards viewing it as a buying opportunity (but I claim the right to change my mind).
Finally, I’d like to thank Alexander Eliasson (@alexeliasson) and Shadowart (@5hadowart) for providing me with their thoughts on the idea.
Disclaimer: This is a brief text on a stock I find interesting based on my interpretation of the information I’ve gathered. It’s not advice. It’s probably sprinkled with at least some of my own misconceptions and/or logical missteps, so please read critically and always feel free (or forced) to correct me. Even worse, any logical missteps are likely to be amplified by my heavy use of “back of the envelope”-maths. If you have questions, comments, or knowledge about the industry or company that you wish to share, please send me an e-mail: hariseldomright@gmail.com.
As of this writing, I have a small position (~10% of my portfolio) in Krynicki Recykling (WSE: KRC). My shares were bought at prices between 18-20 PLN. I may decide to buy or sell any amount, at any point, at any price, and for any reason.
Great article. I've been trying to find more information on Polish companies as their market seems so cheap, but there is the language barrier. One thing I'm having trouble understanding is looking at some of their data they seem to pay out most of their profits as dividends, so where do they get the money to expand capacity? I've also notice a similar issue with Mo-BRUK