-Revenue and income have been fairly flat for the past six or seven years.
-Dividend Yield: 4.63%
-Five-year dividend growth: 9%
-Balance Sheet: Unimpressive, but reasonable and stable for the industry.
WM has a great business model and a strong competitive advantage, but nonexistent growth and heavy debt should rightly weigh down the valuation. I think WM makes a decent pick for current dividend yield and dividend growth at around $30 a share.
OverviewWaste Management (WM) is the largest processor of waste in North America. With over 43,000 employees, WM collects tens of millions of tons of waste in a year, and recycled 8.5 million tons of material in 2010. They also generate energy via landfill gas and through burning waste.
Waste Management has a rather unappealing business to most: They deal with trash. But from an economic perspective, their business model is enviable:
-Customers pay Waste Management to remove their waste.
-Waste Management recycles the material that is recyclable and gains some cash flow.
-Waste Management can use a combustion process to turn waste into energy — enough to power about 650,000 homes which, provides another stream of cash flow.
-Waste Management deposits a lot of trash into landfills and generates additional cash flow by charging fees for lesser waste companies to also deposit trash into their landfills.
-Waste Management uses the methane that comes up from landfills to produce electricity for which they can generate more cash flow. They generate about 500 megawatts of electricity this way, which can power about 400,000 homes.
Revenue breakdownWaste Management’s $12.515 billion in revenue for 2010 came from the following streams:
Collection accounted for $8.247 billion in revenue.
Landfill accounted for $2.540 billion in revenue.
Transfer accounted for $1.318 billion in revenue.
Wheelabrator (waste-to-energy) accounted for $889 million in revenue.
Recycling accounted for $1.169 billion in revenue.
“Other” accounted for $314 million in revenue.
Intercompany accounted for ($1.962 billion) in revenue.
Collection For commercial customers, WM typically makes a three-year agreement and charges fees based on a variety of factors. They supply metal containers with their logo, and trash can usually be picked up by a truck with only one employee. For residential customers, WM typically makes a 1-5 year agreement with an organization such as a municipality or homeowner’s association for exclusive collection rights in that area. They also charge some residents directly depending on location.
They have also launched a new product called Bagster, which is a strongly woven bag that can be purchased at certain stores. It can hold three cubic meters of material, and is more economical for medium-sized trash projects than renting a metal dumpster. After purchasing and filling the bag, a customer calls WM to have the bag picked up for a fee. It’s useful for small home renovation, clearing out junk, and certain business applications.
Landfill WM operates 271 landfills. They deposit most of their collected trash into their own landfills, which keeps the profit margins high. WM charges fees for other trash collectors to deposit into their landfills. After a landfill is full they cover it with earth so it can be used for other purposes. WM also operates five hazardous waste landfills.
Transfer WM uses transfer stations to compact trash and then send it to a landfill. In more urban areas, landfills may be far away from the pickup site, so WM and other garbage collection companies deposit trash into the transfer station. WM charges fees for their services to other collectors.
Wheelabrator WM owns or operates energy-to-waste facilities and independent power production plants. WM burns solid waste to boil water to produce steam that produces electricity, which they can sell into wholesale electricity markets.
Recycling WM recycles plastics and commodities from their collection activities.
-WM manages the marketing of recycled materials for third parties.
-WM provides sustainability services to businesses.
-WM collects methane from their landfills and sells it to produce electricity.
-WM offers solutions for healthcare waste.
-WM invests in companies that are supplementary to their own industry.
-WM rents out portable restrooms and provides some street-sweeping work.
Revenue, Earnings, Cash Flow and MetricsRevenue, earnings and cash flow have been lackluster for the last several years.
MetricsReturn on Equity: 15%
Price to Earnings: 15
Price to Book: 2.2
Price to Free Cash Flow: 12
Dividend GrowthBased on the current dividend of $0.34 per share per quarter, WM has a dividend yield of 4.63%. WM has had a regular dividend history since 2004 where they began raising their quarterly dividend each and every year.
The payout ratio is increasin, since the dividend is increasing, but the EPS is remaining fairly static. In 2006, the payout ratio was 42%. For 2010, the payout ratio is 64%.
Share RepurchasesWM has avidly repurchased its own shares. Between 2005 and 2010, WM had a net repurchase of stock of about $3.7 billion. This is more than a quarter of the current market capitalization of the company. This makes EPS grow faster than net income (or in WM’s case, decrease less than net income), and fuels dividend growth (the total dividend payout has grown much more slowly than dividends per share).
Number of Shares
Balance SheetWM has a balance sheet that is not as clean as I would like. They have a total debt/equity ratio of 1.42 and an interest coverage of only 4.2. Ninety percent of shareholder equity consists of goodwill.
This is a rather unattractive balance sheet by most standards, but for WM, it’s not too bad. For balance sheets, apples need to be compared to apples, rather than to oranges. WM’s balance sheet compares reasonably to its largest competitor. As far as the balance sheet is concerned, WM has the balance sheet of a utility. Utilities are expected to have high debt/equity ratios and low interest coverage ratios, because they require a lot of assets to operate, have low return on assets, and generate very consistent cash flows which allows them to take on leverage in order to increase return on equity while still remaining fairly conservative and stable. Because WM has extremely strong free cash flows, and has a very large competitive advantage with its necessary business, it can comfortably take on debt, and has maintained stable debt for a while now. However, I think WM would make a better investment if the debt/equity ratio was closer to 1, and the interest coverage ratio was over 5 or 6. The current amount of debt is acceptable, however, as long as the valuation justifies it.
Investment ThesisThe average person disposes of 4.5 pounds of waste every day. Trash is a fairly defensive business because regardless of how the economy is, people are still throwing things away, and trash removal is absolute necessary. Still, a sluggish economy reduces the volume of trash, and modestly decreases profitability. Since WM has a lot of fixed, asset-heavy costs, a greater volume in trash results in better profits for WM. This is why the net profit margin hit a peak of 9% and then decreased to below 7.5%
I feel that the five-year periods of the quantitative aspects of WM don’t quite do the company justice. There was slow growth, and then the recession erased it and reversed it. I think that going forward, WM’s growth over the next five years will be better than their lack of growth over the previous five years. Even if the company can simply maintain static net income, the share repurchases would increase EPS at a reasonable rate, or the company can redirect some cash flows to reduce the debt, which would reduce the interest payments and increase net income and EPS. Stabilized net income and continuing share repurchases would stabilize the payout ratio, and lead to long-term sustainability of dividend growth.
Waste Management is focusing on growing its recycling and renewable energy abilities. WM currently uses waste as an energy source to power 1 million homes. By 2020, they plan to double that number to 2 million homes. WM currently recycles over 8 million tons of material annually. By 2020, they plan to nearly triple that number to over 20 million tons. They have been making recycling easier for residents, and have also added new services like electronics recycling.
All things considered, I think there are some catalysts for growth. If the U.S. economy heats up, volume should return and profitability should increase to the levels of previous years, at least. WM is focusing on powering its trucks with liquified natural gas rather than diesel, which can reduce exposure to volatile energy prices, and the company estimates it will save money. The company now has over 1,000 LNG trucks, which is only a small part of the fleet, but quickly growing. WM’s increasing focus on generating renewable energy and recycling could continue to drive profits.
RisksWaste Management’s core industry of trash is always going to be necessary, but WM does face risks. They are susceptible to energy prices for powering their vast army of vehicles and operations. While they are in a conservative industry, they are still susceptible to economic weakness because trash output decreases during times of economic recession. Waste Management also faces risks in the form of contract losses to competitors if they don’t manage their business well. Focuses on environmental sustainability, and business initiatives to produce less trash, can potentially reduce volume for WM. Nonetheless, they do have a strong, firmly entrenched business.
Conclusion and ValuationWhen I analyzed WM in 2010, I considered the company to have a great business model, but that it was a bit overvalued, with a P/E of 16 and a price in the low $30s. Now that the valuation has been reduced, while most else has remained the same, I consider WM to be fairly valued.
Investors in WM get a 4.6% dividend yield and 9% dividend growth. I don’t think the 9% dividend growth is sustainable for the long term, but if WM stabilizes and slowly grows its net income, and if continued share repurchases begin increasing EPS, I think WM could grow the dividend at 4-5%. This is based on the fact that WM generates more than $1.1 billion in free cash flow, which represents 8% of the market cap, and uses all of this money to pay dividends and buy back shares.
If WM can grow net income at a rate that slightly exceeds inflation, and continues returning money to share holders in the form of dividends and buybacks, I think WM could grow the dividend by at least 5% annually for the long term, which when combined with the current dividend of well over 4%, results in a rate of return of around 9% or so as long as the valuation remains roughly the same. That’s a pretty solid risk-adjusted return potential for this business.
Full Disclosure: I do not own Waste Management stock at the time of this writing.
- WM manages the marketing of recycled materials for third parties.