Waste Management, Inc. Stock Analysis – Too Expensive for Me (part 3 of 3)

(Last Updated On: October 5, 2017)

Summary

  • This Waste Management, Inc. stock analysis is the 3rd of a 3 part series on the largest non-hazardous solid waste collection companies.
  • The non-hazardous solid waste collection industry is highly fragmented due to its low entry barriers.
  • Growing to a meaningful size is not easy and requires readily accessible sources of capital.
  • The largest players within the industry have a sizable pool of acquisition opportunities.
  • WM has not experienced any significant top line growth over the last 10 years but is growing EBITDA and FCF.
  • WM might be attractive to some investors but I view it as too expensive at current levels.

Introduction

This is the third of three articles wherein I review the three largest companies in the North American non-hazardous solid waste collection, transfer, disposal, recycling and energy services business.

This post covers the largest publicly traded company in this space:  Waste Management, Inc. (NYSE: WM) with a market cap of ~$33.3B. An Industry Review is excluded from this post but can be found in my first post within this series.

Business Review

WM’s revenue base is highly diversified. In FY2016, for example, its largest customer represented 1% of annual revenues.

As at December 31, 2016 (fiscal year end), WM employed ~41,200 people and owned or operated 248 landfill sites. It managed 310 transfer stations that consolidate, compact and transport waste efficiently and economically. This makes disposal more practical for larger urban markets where the distance to landfills is typically farther.

WM is North America’s leading provider of comprehensive waste management environmental services which include:

  • “Solid Waste” business – operated and managed locally by subsidiaries that focus on distinct geographic areas and provides collection, transfer, disposal, and recycling and resource recovery services.
  • “Traditional Solid Waste” business – excludes recycling and resource recovery. Through its subsidiaries, WM is a developer, operator and owner of landfill gas-to-energy facilities in the United States.
  • The use of waste to create energy – gas which is produced naturally as waste decomposes in landfills is recovered and is sold for use in generators to make electricity.
  • The recycling of materials that include paper, cardboard, glass, plastic and metal.

Readers interested in learning more about the multiple Risk Factors WM faces are strongly encouraged to review WM’s 2016 Annual Report for the fiscal year ending December 31, 2016. A comprehensive list of the risks commences on page 83 and ends on page 95!

Note that WM’s Net Income has experienced some volatility in the last few years. The following explains why.

WM Ratios from Morningstar
WM Ratios from Morningstar

Source: Morningstar

Energy and Petroleum (E&P) waste can be a significant source of income for the industry. Income is generated from the removal of the waste by-products of oil and natural gas production. This source of revenue was a significant driver of earnings but the downturn in the oil and gas industry had an impact on some non-hazardous solid waste collection, transfer, disposal, recycling and energy services businesses to a greater extent than others; WM was hit hard.

During FY2013, WM recognized $0.509B of goodwill impairment charges primarily related to its Wheelabrator business ($0.483B), its Puerto Rico operations ($0.01B) and its majority-owned waste diversion technology company ($0.009B). It also recognized net charges of $0.464B primarily related to landfill impairments ($0.262B), waste-to-energy impairments ($0.144B), and other impairments totalling $0.066B. While these charges negatively impacted Net Profit and EPS, they had no impact on Operating Cash Flow and Free Cash Flow.

As part of its ongoing assessment of all facets of its operations, WM decided to exit its Wheelabrator Technologies Inc. business which provided waste-to-energy services and managed waste-to-energy facilities and independent power production plants. The sale of this subsidiary was completed in December 2014 and resulted in a ~$0.762B decrease in revenues in FY2015.

In FY2015, WM incurred significant “other expenses”. Roughly $0.4B of the net increase relative to prior years was attributable to higher litigation settlement costs and WM’s continued focus on controlling costs.

Further details regarding these impairment and other charges can be found in the notes to WM’s Annual Reports/10-Ks which can be found here.

Q2 + 1H FY2017 and Guidance for Remainder of FY2017

On July 26, 2017, WM released its Q2 + 1H FY2017 and Guidance for Remainder of FY2017. In a nutshell, Q2 results were positive. An improvement in core pricing, the addition of profitable volume, and tight cost controls resulted in strong cash flow and EBITDA; WM achieved its highest ever quarterly operating EBITDA and FCF grew ~13% relative to Q2 2016 despite a significant increase in cash taxes paid.

The conversion rate of operating EBITDA to FCF has increased over the past 3 quarters; it increased to >50% in Q2 2017.

WM Q2 2017 Earnings Overview
WM Q2 2017 Earnings Overview

Source: Waste Management’s website

As noted in the Business review section of this post, WM is not solely in the business of hauling trash to landfill sites. It is also in the recycling business and the brokerage business.

The brokerage business revenue grew ~10%. While margins are much lower (4% – 6%), it is good business from a strategic standpoint. It is now becoming a substantial percentage of WM’s revenue and is about 2 times larger than WM’s largest competitor’s total recycling revenue.

This brokerage business is ~50% of WM’s total recycling revenue and the additional tonnage generated from this area enables WM to command a slightly higher price per ton. A reason for this is that WM’s customers who use this recycled commodity can be assured to get a consistent and high-quality volume.

The brokerage business has a high return on investment in that it requires virtually no WM capital. This is because the large volume recyclers have their own capital equipment (eg. balers) and they manage the volume. All WM does is help the recyclers sell their product.

Long-Term Debt

This is a highly capital intensive industry. Leverage is used to fund fixed assets and mergers and acquisitions.

The following snapshot of WM’s debt position was taken from page 161 of the pdf version of the 2016 Annual Report.  There does not appear to be any significant debt coming due in the short-term.

WM - Debt snapshot
WM – Debt snapshot

Source: WM’s 2016 Annual Report/10-K

Credit Rating

On February 24, 2017, Moody’s changed WM’s outlook to positive, affirmed a Baa2 rating and assigned a P-2 Commercial Paper rating as WM planned to initiate a $1.5B commercial paper program.

Moody’s Rating Scale and Definitions can be found here.

Dividends and/or Share Buybacks

WM’s dividend history can be found here. Currently, the dividend yield is ~2.2% based on a stock price of ~$76.

While WM is a Dividend Achiever (10+ consecutive years of dividend increases) having increased its dividend for 14 consecutive years, these dividend increases have been relatively small in recent years.

The chart in the Compound Annual Growth Rates section of this post reflects the dividend growth rate for WM up to FY2016 since this is the most recent year in which dividend data is available for all four quarters. If I use the historical trend, however, and presume that WM’s dividend will remain at $0.425/quarter for all 4 quarters in the current fiscal year, I get an annual dividend of $1.70 for FY2017; this results in a dividend growth rate of ~3.66% relative to FY2016.

I am currently retired so I like a steady stream of dividend income which increases at a rate in excess of the rate of inflation. I will not chase yield, however, as I view this strategy as fraught with risk.

In the case of WM, I see a company that already pays out a significant proportion of its earnings in the form of dividends or share buybacks. While it has ample FCF to increase the dividend payout, it appears management is more prepared to buy back shares or it may be more inclined to acquire smaller players within the industry if/when valuation levels become more reasonable rather than instituting a dramatic increase in the annual dividend growth rate. I see nothing wrong with this strategy and will leave it to management to determine the best use of cash.

Valuation

On July 26 th, WM announced that it is on track to meet the upper end of its FY2017 guidance of adjusted earnings per diluted share of $3.14 – $3.18 and free cash flow of $1.5B – $1.6B. In Q2 it repurchased $0.25B of its common stock and in Q3 it expects to repurchase an additional $0.5B in common stock.

WM TD WebBroker EPS Estimates
WM TD WebBroker EPS Estimates

Source: TD WebBroker

Multiple brokers have projected 2017 Adjusted EPS of $3.19/share but given management’s expectations noted above, I will use $3.18 for my purposes. Using the current stock price of ~$76, I get a forward PE of ~24. I provide the following so you can see how this level compares to historical PE levels.

WM Morningstar PE Ratios
WM Morningstar PE Ratios

Source: Morningstar

Compound Annual Growth Rates

The following compares the Compound Annual Growth Rates for various metrics for all three companies covered in this series of posts; WCN is more of a growth story than RSG and WM.

CAGR for WCN RSG and WM
CAGR for WCN RSG and WM

Source: 2007 – 2016 Annual Reports for WCN, RSG, and WM

Further details on this subject matter can be found in the Compound Annual Growth Rates section of my Waste Connections (NYSE: WCN) stock analysis.

Waste Management, Inc. Stock Analysis – Final Thoughts

As noted in the first two posts of this series, I find the highly fragmented non-hazardous solid waste collection, transfer, disposal, recycling and energy services industry to be extremely attractive. Regrettably, I view current valuation levels as somewhat inflated

I recognize WM might currently constitute roughly 5.9% of Bill Gates’ portfolio. This simply indicates to me that WM meets his investment criteria. I strongly suspect, however, that he did not acquire his WM shares at valuation levels similar to those we are currently witnessing.

In my opinion, too many investors think the top three waste management companies are wonderful companies in which to invest. As a result, this has pushed up WM’s stock price to a level I view as being a bit more expensive than what I would be prepared to pay. If I acquire WM at current levels I suspect I am likely to be less than pleased with my investment. I will, therefore, refrain from initiating a position and will patiently wait for some event/events to result in a retracement in WM’s share price at which time I will re-evaluate whether I want to add it to my FFJ Portfolio.

Note: I sincerely appreciate the time you took to read this post. As always, please leave any feedback and questions you may have in the “Contact Me Here” section to the right.

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I currently have no position in WM and am unlikely to initiate a long position within the next 72 hours.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.