CA - Waste Management: A Good Investment For Wealth Preservation

2023-05-16 09:50:14 ET

Summary

• WM has a competitive advantage in a durable industry protected by high barriers to entry.
• But because of their high valuation and what is priced into the share price, I would not bet on them beating the index over the next 10 years.
• Nevertheless, positions taken in the $120 range would skew the advantage very much in favor of outperformance.

Thesis

I believe Waste Management, Inc (WM) is an excellent investment for people who want to preserve their wealth because it operates in a market that will still be important 100 years from now. But I think future returns are likely to be lower than they have been over the past decade because much of the outperformance has come from multiple expansion and I do not see much room for more multiple expansion going forward.

WM is a high quality company, but I do not think it is the right time to take a position if your goal is to beat the index. However, lower multiples could help improve total return prospects.

Analysis

WM operates in a market that is highly regulated and therefore has high barriers to entry, which helps the larger players such as WM and because of its size, WM has competitive advantages over its smaller rivals due to economies of scale. In addition, WM, Republic Services ( RSG ) and Waste Connections ( WCN ) together account for more than 2/3 of the US market.

And if we use ROIC as a quality measure, we see that WM is the highest quality company out of the 3. We believe they are leaders in a market with high barriers to entry and future growth potential in the renewable and recycling sectors. This bodes well for the company's future.

But it is also clear from the profit margins that the 3 companies are in a very competitive situation. No company has a clear advantage in profit margins, and the leaders change frequently.

Waste Connection has a bit of a premium in terms of PE multiples over the last 5 years, but the other two are also high with multiples over 30. I would argue that in an environment of higher interest rates for a longer period of time, the PE multiple would probably be more in the low 20s.

So if you want to have good future returns, they have to offset this possible multiple contraction ether through high earnings growth or higher dividends/buybacks. But at the moment, the long-term value added of share buybacks is around 1% per annum , and dividends are likely to add 1.75% per annum to total returns .

So net income needs to grow strongly in the future and the 10-year CAGR looks quite good at ~10%, but the last 5 years have been relatively poor with a CAGR of less than 1%.

But if we give them a growth rate of 6% over the next 10 years because of attractive future growth opportunities and combine this with the other assumptions, we get the following 10-year return outlook.

• Earnings: 1.79
• Multiple: 0.7
• Shares Outstanding: 1.1
• Dividends: 1.19

1.79 x 0.7 x 1.1 x 1.19 = 1.64x over 10 years, or 5.07% per year.

And even if we give them the same multiple in 10 years' time, which is unlikely, we see that the returns are not overwhelming.

1.79 x 1.0 x 1.1 x 1.19 = 2.34x over 10 years, or 8.87% per year.

The S&P 500's total return is usually ~10% per annum, so both scenarios would likely underperform, leading me to conclude that lower multiples should be sought by those seeking to beat the index.

EV/EBIT multiples in the 15x range should be a good bet for investors looking for an attractive entry point, and there have been times in the past when such a multiple has been available.

WM has many attractive business prospects in the future with its investment in automation, which is likely to improve margins, and although they are more expensive than the competition, they are more reliable, as some customers have told them after going away and coming back .

If we look at the Reverse DCF to see what is currently priced in, we see that diluted EPS TTM would have to grow by 14% per annum to justify the current share price, which is clearly not an easy task and further reinforces my view that WM is probably overvalued. After all, the five-year average diluted growth rate is only ~10% .

Therefore, I would think that a price in the $120 area has a much better chance of outperforming the index. However, if WM decides to return more cash to shareholders via buybacks or dividends, the attractive price region could change.

Conclusion

WM is probably the highest quality company with a small lead in a very durable market with high barriers to entry, and when you combine that with a good valuation, it would be a very interesting long-term holding. But unfortunately, the valuation is not very attractive at the moment if you are looking for double-digit annual returns.

But not everyone wants to beat the market, and some are looking for investments that will do well regardless of economic conditions. And I believe WM is such an investment, which is likely to have less volatility than the market and is therefore something for people who do not like the big swings of some other companies.

And better entry points could still lead to long-term outperformance, as the only criticism I have at the moment is that the multiple is too high and that the balance sheet has been more robust in the past.

For some, the debt situation may be a factor, but at 8x interest coverage it should not be a major issue, although l ong-term debt should be monitored as it has increased by almost 80% in the last 10 years. By comparison, the S&P 500's interest coverage for all companies excluding banks is about 10x, which is slightly better than WM's.

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