When I’m looking for an investment, I try to identify companies with a leadership position in their industry. The strength of these companies often leads to growth and an increasing dividend.
This doesn’t mean that I’ll pay any price to acquire shares of a company. I try to avoid overvalued stocks, as I like to buy when I have a solid potential return.
One company that is king of its industry but trades with a rich valuation is Waste Management, Inc (WM, Financial).
Company background
Waste Management is the largest provider of waste management solutions in North America. Services provided by the company include waste collection, recycling, transfer and disposal services. The company’s customer list includes residential, industrial, commercial and municipal entities.
One positive in Waste Management’s favor is that the company has a diversified footprint in North America.
Source: Waste Management’s May Investor Presentation, slide 6.
The vast majority of physical facilities are located in the U.S. and near densely populated areas. This gives Waste Management access to a sizable potential customer base as well as some protection in case one area of service suffers a slowdown. In addition, Waste Management’s revenue stream is very diversified, as shown in the chart below.
Source: Waste Management’s May Investor Presentation, slide 8
Last year, only two types of collection contributed more than 12% to total revenues. Only one election type (public sector) contributes more than 20% of revenues. This should help provide some support for the company if one or more collections types shows signs of weakness in its business.
As of June 22, Waste Management serves more than 21 million customers across the U.S. and Canada and trades with a market capitalization of just under $43 million.
Quarterly highlights
Waste Management reported its first quarter earnings results on May 6. Revenue increased by 0.9% year-over-year to $3.7 billion, slightly ahead of what the market had anticipated. Earnings per share decreased 1 cent, or 1.1%, to 93 cents, which was in line with what Wall Street analysts had expected.
The company attributed higher revenue growth to volume increases in the collection and disposal business. This increase added $74 million to total revenues. Operating Ebitda grew 2.6% to $1.01 billion for the first quarter. The average price of recycling decreased 30% to $40 per ton during the quarter, but this business still managed a $3 million improvement in Ebitda.
Looking at the individual lines of business, residential volumes grew 25%, commercial volumes declined 16% and third-party landfill tons and industrial hauls were lower by 20%. Restaurants, retail and offices normally contribute 60% of commercial revenue.
On the plus side, Waste Management’s core pricing improved by 1% to 5.5%, with all lines of business above 4%. The company also took steps to rein in costs during this time. While Waste Management has guaranteed 40-hour work weeks to all full-time employees, they have reduced overtime, commercial routes and industrial routes. The company has also grounded 6% of its routed vehicles. This will help to reduce costs as certain customers have less need for services.
Despite lower commercial volumes overall, the company has had less than 1% of customers cancel service. This should help the company continue to grow EPS, something Waste Management has done 14 out of the last 16 years.
Waste Management has more than doubled its EPS over the last decade. The company has increased its EPS with a growth rate of 7.7% annually over this period of time.
Waste Management has repurchased 51 million shares, or 10.7% of shares outstanding, since 2010, while net income has improved by 6.4% over the last 10 years. The net profit margin has increased from 8.1% in 2010 to 12.2% last year/
Waste Management had expected to earn $4.60 in EPS in full-year 2020, but the company pulled its guidance for the year due to the pandemic. The company also suspended share repurchases. According to Yahoo finance, analysts expect EPS of $3.63 for 2020.
Source: Waste Management’s May Investor Presentation, slide 4
Waste Management ended the first quarter with a $10 billion net debt position, but interest expense on that debt was just $112 million in the first quarter and $427 million over the last four quarters. Currently-owed debt is just $387 million, so Waste Management doesn’t appear to be encumbered financially.
All things considered, Waste Management looks well positioned both when dealing with the pandemic and with future business. Waste removal will always be an important part of life for consumers and businesses alike. This essential service likely means that the largest player in the industry should continue to grow in the years to come.
Dividend and valuation analysis
Waste Management increased its dividend by 6.3% for the March 20 payment. This marks the 17th consecutive year of dividend growth for the company. Waste Management has increased its dividend by an average of:
- 7.7% per year for the past three years.
- 6.4% per year over the past five years.
- 5.9% per year over the past 10 years.
Most companies I follow tend to have declining rates of dividend growth, but not Waste Management. The company’s average raise actually improves over the listed periods of time. If there is a hiccup when it comes to the company’s dividend it’s that shares yield just 2.1% at the moment, which compares unfavorably to the average annual yield of 3.1% since 2010.
Using the annualized dividend of $2.18 and predicted EPS for the year, Waste Management has a payout ratio of 60%. This is just above the 10-year average payout ratio of 58% Despite the lowering of expected EPS by almost a $1 for 2020, Waste Management’s payout ratio is nearly in line with its long-term average. Earnings payout ratios often spike when EPS estimates are reduced, but Waste Management’s payout ratio isn’t too far out of the norm.
Waste Management dispersed $236 million of dividends in the first quarter while producing free cash flow of $306 million for a free cash flow payout ratio of 77%. This is higher than I normally would prefer, but looking at the bigger picture shows a much healthier payout ratio.
The company distributed $876 million of dividends last year while generating $2.1 billion of free cash flow for a payout ratio of 42%. From 2016 through 2019, dividends paid equaled $2.3 billion and consumed just 44% of the $5.2 billion free cash flow.
The most recent quarter could very well be a one-off situation with regards to free cash flow. Waste Management’s payout ratio in recent years has been excellent and I would expect it to be so under normal circumstances.
While the company’s business and dividend situation look strong, Waste Management’s valuation is where I begin to have issues with the stock.
Using Friday’s closing price of $101.77 and last year’s EPS of $4.40, the stock has a trailing price-earnings ratio of 23.1. Using this year’s estimates, the forward price-earnings ratio balloons to 28. The 10-year average valuation is 19.7. Shares traded at quite the premium even last year, but the valuation is even higher based on expected 2020 earnings.
The stock has traded with a higher price-earnings ratio since 2015, averaging 22.1 over this period of time. Due to its strength during the pandemic and its utility-like business, I have a target price-earnings range of 22 to 24. Using 2020 estimates, I believe the stock should trade between $80 and $87. This would be a 15% to 21% decline from the current share price.
Final thoughts
Waste Management is king of the trash removal industry. The company was nimble enough to take quick steps to reduce routes and vehicle fleets. The company also saw less than 1% of customers cancel service, showing how essential its business is to consumers and businesses alike. Waste Management has performed well over the long-term, proof that trash can be a nearly recession-proof business.
Due to its steadiness, the company has a dividend growth streak of 17 years and a rather healthy earnings and free cash flow payout ratio. I believe the company’s dividend is quite safe even if it is below its historical average yield.
That being said, Waste Management is expensive using last year’s figures and projected EPS results for the current year. As much as I like the company’s business and dividend growth history, Waste Management’s valuation remains much too high for my liking. I will wait for a pullback before adding the name to my portfolio.
Author disclosure: the author has no position in any stocks mentioned in this article.
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