Skip to Content
Stocks

Waste Management Is at the Top of the Heap, but Shares Look Pricey

We think the narrow-moat waste firm will generate healthy amounts of cash flow in the years to come, but the market is pricing in an overly exuberant scenario.

2016 was a strong year for the U.S. solid waste industry, and narrow-moat Waste Management finished the year firing on all cylinders. Although we’re raising our fair value estimate to $54 from $52 per share on higher assumptions for midcycle operating margins, we believe the market is pricing in quite a bit of exuberance in Waste Management’s shares at present. As such, we recommend that investors wait for a pullback before building positions.

Revenue increased 6.6% year over year to $3.46 billion in the quarter, reflecting strong internal revenue growth of 5.2%, driven by increases in both pricing and volumes. Average pricing yield reached 3.2% in the quarter, as a 16.1% year-over-year increase in recycling commodity prices added to over 2% of pricing gains in collection and disposal. In addition, volumes grew by 2% year over year; this is notable as it was the first time that contribution from volume nearly matched contribution from solid waste pricing in over five years. In addition, customer churn improved by 100 basis points to 9.1%, the lowest percentage seen since 2002, suggesting that higher pricing isn’t sacrificing customer growth. In our view, Waste Management’s recent adoption of customer acquisition tools has made a material impact on the company’s ability to attract higher-quality business, a trend we believe will support better future margins versus historical averages.

Operating EBITDA margins remained largely flat year over year at 26.9% in the quarter; however, this was largely due to an increase in severance costs and incentive compensation, which otherwise masked underlying growth of about 100 basis points. Strong EBITDA performance was the major driver of growth in free cash flow, which reached $387 million in the quarter, or a healthy 11% of sales.

Waste Management Is a Strong Competitor Waste Management's unparalleled dominance in landfill ownership makes it a formidable competitor in the waste industry. The company's network of collection routes creates a symbiotic relationship between hauling and disposal, funneling trash toward its valuable landfill disposal assets. Immediately following the most recent recession, it appeared that Waste Management had lost sight of its core solid-waste business as it focused on growing its recycling business amid a boom in recycled commodity prices. However, since then, focus has returned to maximizing core solid-waste profitability, a strategy that we believe will continue to generate strong shareholder returns. As waste volume grows and the benefits of Waste Management's structured pricing programs build, we expect strong operating leverage will follow suit.

In contrast, persistent underperformance in recycling and waste to energy in recent years caused Waste Management to back away from an earlier exuberance for alternative waste processing. Historically, investors could expect annuitylike revenue streams from collection and disposal contracts; however, volatility in commodity markets primarily governs recycling and waste-to-energy economics, leading to less predictable cash flow streams over time. Over the past couple of years, Waste Management has been successful at renegotiating recycling contracts to include fees for processing costs and contaminated materials. Also, in 2014, it sold the Wheelabrator waste-to-energy business. In our opinion, these actions lessen the company’s exposure to commodity forces beyond its control, which should improve the reliability of longer-term cash flow generation as solid-waste fundamentals continue to improve.

In the near term, we expect Waste Management’s appetite for acquisition to increase, likely focusing on larger, tuck-in opportunities that can increase market share in established areas where price discipline can be reasonably maintained. An enhanced ability to increase price on this acquired volume should become an additional source of cash flow generation over the coming quarters.

Waste Management's narrow economic moat is derived from its industry-leading landfill network, which provides a competitive advantage that is difficult for other waste services providers to replicate. Since the challenges of landfill ownership create significant barriers to entry due to high fixed operational costs, political opposition, and regulatory hurdles, industry players that control the greatest amount of landfill assets ultimately command pricing power in the form of tipping fees, leading to outsize returns on invested capital over time as third-party haulers divert additional volume to remaining landfills. In addition, as collection routes become denser and more streamlined, these operational efficiencies have the potential to fall straight to the bottom line. These advantages allow the company to keep competitors at bay and gain greater control over the entire waste stream over time.

Overall, we assume that Waste Management’s core business excluding recycling will drive the majority of the value in our discounted cash flow analysis. Even as we incorporate relatively modest volume growth assumptions, pricing gains will help the company generate healthy amounts of cash. We allocate future cash toward dividends, share buybacks, and tuck-in acquisition activity consistent with the company's historical uses. Under these assumptions, returns on invested capital (including goodwill) steadily improve and average 10.8%, suggesting that steady core growth supports value creation.

More on this Topic

Sponsor Center