-Seven Year Annual Revenue Growth Rate: 0.6%
-Seven Year Annual EPS Growth Rate: Negative
-Seven Year Annual Dividend Growth Rate: 8.5%
-Current Dividend Yield: 3.63%
-Balance Sheet Strength: Leveraged, Stable
I view WM to be overpriced currently at around $40. One-time charges for this year result in an understated EPS figure and consequently an overstated earnings multiple, but even factoring that in, the lack of growth and the shrinking margin between dividends and earnings makes for a difficult-to-estimate valuation.
OverviewWaste Management (NYSE:WM) is the largest processor of waste in North America. With over 44,000 employees, WM collects tens of millions of tons of waste in a year, and recycled 9 million tons of material in 2012. 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 700,000 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 enough energy this way to power about 500,000 homes.
Revenue breakdownWaste Management’s $13.649 billion in revenue for 2012 came from the following ways:
Collection accounted for $8.405 billion in revenue.
Landfill accounted for $2.685 billion in revenue.
Transfer accounted for $1.296 billion in revenue.
Wheelabrator (waste-to-energy) accounted for $846 million in revenue.
Recycling accounted for $1.360 billion in revenue.
“Other” accounted for $1.416 million in revenue.
Intercompany accounted for ($2.359 billion) in revenue.
CollectionFor 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 like 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.
LandfillWM operates 269 landfills; 211 are owned by the company and 58 are operated through leasing or contracting. 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 5 hazardous waste landfills.
TransferWM uses 297 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.
WheelabratorWM owns or operates 17 waste-to-energy 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.
RecyclingWM recycles plastics and commodities from their collection activities.
Other-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.
RatiosPrice to Earnings: 23
Price to Free Cash Flow: 24
Price to Book: 2.9
Return on Equity: 13%
(Chart Source: DividendMonk.com)
Waste Management’s lack of revenue growth is the principle problem currently, as it has only grown by about a half a percent per year over the last seven years. Inflation itself was higher than that, so real revenue growth was negative. A sluggish macroeconomic environment, most likely combined with the fact that North America is increasingly a service-based economy, is detrimental to trash volume growth. Fixed costs don’t change a whole lot from year to year, so volume is the key variable for a higher profit margin and overall growth.
Earnings and Dividends
(Chart Source: DividendMonk.com)
Earnings growth was negative over this period, moving from $2.09 to $1.76 between 2005 and 2012. Company-wide net income fell even further, from $1,182 million to $817 million, but was buoyed by share repurchases to reduce the share count and assist the EPS figures.
The current dividend yield is 3.63%, the dividend grew at 8.5% per year on average over the last seven years, and the payout ratio from earnings is 82%. Since the current dividend is covered by both earnings and free cash flow, it appears to be safe for now. A picture is worth a thousand words, though, and with decreasing EPS and an increasing dividend per share, the chances for the dividend growth to stall are becoming larger. Less likely, but still possible, is the issue of a potential dividend cut if this continues for a few years.
For 2012, EPS isn’t in quite as much trouble as it looks. The company reported an adjusted figure for 2012 earnings of $2.08, compared to the reported EPS figure of $1.76. Management justified this adjustment by listing the one-time restructuring and asset impairment charges which affected earnings in the year. Compared to the adjusted $2.08 figure for 2012, analysts collectively are expecting $2.18 in earnings for 2013 and $2.37 for 2014. Consistent growth of that sort, which we haven’t seen in the last decade, would actually make WM a decent value at the current price.
Balance SheetWaste Management’s balance sheet is a weak point, but when the company’s consistent revenues from a necessary, asset-heavy industry are thought of basically as a utility, its balance sheet remains reasonable.
Total debt/equity is over 150%, and all of equity consists of goodwill. Total debt/income is a bit over 12x. The interest coverage ratio is only 3.8x, meaning operating income covers interest expenses less than four times over.
Overall, I view the balance sheet as a bit stretched, but not risky in the short term. If volumes/revenues don’t improve, then the balance sheet could become strained in the next several years.
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 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 over 9% and then decreased to below 6%
Much of Waste Management’s shareholder return has historically been from internal use of capital. Revenue growth is low, and the company uses practically all of its profit/cash to pay dividends and buy back shares, which together results in a shareholder yield that is typically over 5% in a given year, and usually much higher. This last year of 2012 was an exception, as the company stopped buying its own shares for the year.
Ideally, the business model allows for mild volume growth, combined with price increases to keep up with inflation, resulting in modest revenue growth. Low single-digit revenue growth combined with a 5-7% shareholder yield can result in potentially 9% rate of return from a stable trash business. During these last several years, due to a lack of volume growth, the impact of commodity cost, and one-time restructuring costs and impairments, reality hasn’t matched up.
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, though they have been offsetting some of this by using their own liquified gas for vehicles. 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. If net income doesn’t stabilize and resume mild growth, dividend growth is at risk.
Conclusion and ValuationMy report on Waste Management last year stated that the price looked fair in the low $30′s where it was at the time, but that there were concerns due to the static revenue and EPS figures. Over the last year, the stock price jumped about 20% to over $40/share while reported income decreased. Adjusted income was basically flat. An unbroken continuation of dividend growth increased the payout ratio from earnings, bringing it above 80%.
Usually I’d estimate a fair price based on the Gordon Growth Model, but it wouldn’t be prudent to do so this year. There isn’t any proof of growth; the company would have to regain some momentum for it to be appealing for dividend investors. If the company were to enjoy 1% annual volume growth, 2% pricing growth on that volume, a 4% dividend yield, and a 2-3% buyback yield, without major impairments or increases in the prices of typical expenses, then 9-10% returns each year are not hard to imagine, and a the current price would be realistic. This is approximately what the previously-mentioned analyst EPS estimates for the next two years are implying, in terms of EPS growth.
Based on a comparison of growth and stability, I certainly wouldn’t pay a higher earnings multiple for Waste Management than I would for Coca Cola (KO), which is what the market is currently asking investors to do.
Full Disclosure: As of this writing, I have no position in WM, and am long KO.