2023-08-21 04:48:27 ET
Summary
- Waste Management is a superior company with a defensive business model, high recurring revenue, and a healthy balance sheet.
- The company has consistently outperformed the S&P 500 over the last five years with a strong risk-adjusted return.
- WM's innovative initiatives, such as converting waste into energy, contribute to its long-term growth potential.
Introduction
As most of my readers know, I have a physical watchlist (a piece of paper) on my desk, which contains the stocks I want to add to my portfolio at some point - depending on the timing, macro environment, and business developments.
On that list, I have stocks like Rexford Industrial Realty ( REXR ), Tractor Supply Company ( TSCO ), Abbott Laboratories ( ABT ), Zoetis ( ZTS ), and others.
In light of rising tension in the stock market (see the chart below), I'm more frequently revisiting the stocks on my watchlist, as I hate missing good opportunities.
One of the stocks I'm watching almost daily is Waste Management ( WM ) , the star of this article.
While I didn't want to add yet another industrial stock to my portfolio (roughly 50% industrial exposure), I believe that Waste Management is a superior company and a perfect fit for my portfolio.
The company checks all boxes in my Buffett-style investment criteria sheet (a work in progress), as it has a defensive business model, high recurring revenue, high entry barriers, a healthy balance sheet, anti-cyclical demand, a steadily rising dividend, and subdued volatility.
In fact, over the past five years, WM's risk/adjusted return has gotten so good that it has beaten the S&P 500 with (almost) the same volatility.
In this article, we'll discuss all of this as I explain why I'm looking to add yet another industrial stock to my portfolio.
Why Waste Management Is Superior
With a market cap of roughly $64 billion, Waste Management is the largest company operating in the industry with the same name: waste management.
Originally founded as USA Waste Services, Inc. in 1987, WM turned into the mature company it is now in the late 1990s through M&A and the organic expansion of its footprint.
WM's extensive landfill network, covering 259 sites across the United States and Canada, is the backbone of its operations. Designed with environmental safeguards and constructed in compliance with rigorous regulations, these landfills play a key role in North American waste management, which gives the company a sizeable moat - despite competition risks.
Going back to January 2000, the stock has returned 12.6% per year. It has beaten the S&P 500's 6.8% return, as the index suffered from the tech sell-off in the early part of the new century.
Furthermore, during this period, WM had a standard deviation of 21.0% versus 15.4% for the S&P 500. This is a terrific number, and it results in a much higher risk/adjusted return (Sharpe Ratio) for WM shares.
Over the past five years, WM shares have returned 14.7% per year, beating the S&P 500's 12.0% return. The standard deviation was 19.6%, which is less than 100 basis points above the well-diversified S&P 500's standard deviation.
On top of that, WM has a healthy balance sheet with a 2.7x 2023E net leverage ratio and a BBB+ credit rating from Fitch. It has an A- rating from S&P Global.
Our leverage ratio at the end of the quarter was 2.8 times, which is well within our targeted ratio of between 2.5 and 3 times. About 21% of our total debt portfolio is at variable rates, and our pretax weighted average cost of debt for the quarter was about 3.8%. Our balance sheet is strong, and we remain well positioned to fund growth. - WM 2Q23 Earnings Call
On top of having a mostly anti-cyclical business model and a healthy balance sheet, the company benefits from a number of other factors that make it such a safe-haven play.
- More than half of its contracts are priced at open-market prices, meaning the company has room to hike prices beyond the rate of inflation.
- Non-open-market contracts are linked to inflation indicators. This can be regional inflation indicators or inflation with a small margin on top.
- The company is using its existing footprint to turn trash into energy.
This is what I wrote in my prior WM article :
[...] WM announced plans to invest $825 million over the next four years to convert methane from garbage dumps into biomethane , a renewable natural gas substitute. The company aims to bring 1 7 new projects online across the United States and Canada by 2026 , in addition to the 16 projects it currently operates.
Furthermore:
The company also intends to sell the gas to utilities, industrial firms, and organizations seeking to enhance their environmental credentials . The demand for renewable natural gas is strong among companies and governments aiming for decarbonization, and pricing premiums vary, with landfills typically offering the least expensive source.
Furthermore, despite elevated CapEx requirements to fund its expansion, WM is expected to have consistent free cash flow growth.
Next year, the company could generate $2.3 billion in free cash flow, which translates to a 3.5% FCF yield.
As the company doesn't need to prioritize financial health, this is terrific news for its dividend.
- Waste Management currently yields 1.8%.
- This dividend is protected by a 48% net income payout ratio and a 70% cash payout ratio. The cash payout ratio is set to fall to 51% using 2024 free cash flow estimates.
- The company has hiked its dividend for 20 consecutive years.
- The average annual dividend growth rate of the past five years was 8.7%.
- On February 6, the company hiked by 7.7%.
While a 1.8% yield isn't something income-oriented investors are looking for, I believe it's no reason to avoid WM - especially not because it seems to be in a great spot to maintain solid dividend growth, potentially becoming a dividend aristocrat in 2028.
So, what about the valuation?
Recent Events & Valuation
Economic challenges like lower consumer sentiment and sticky inflation aren't being avoided at WM.
In the second quarter, the company faced several challenges, including persistent cost inflation, slower event-driven volumes, and unexpectedly lower renewable energy prices.
Clean-up volumes related to Hurricane Ian were notably lower than anticipated, resulting in a $9 million operating EBITDA impact.
However, the pricing results for the first half of the year were strong, with the company successfully adjusting its pricing to counteract rising costs.
As a result, the company achieved strong results, including an increase in operating EBITDA of 6.2% and improved SG&A costs as a percentage of revenue by 30 basis points to 9.1%.
Investments in customer experience and automation have led to reduced cost structures and improved customer satisfaction.
Related to that, operating EBITDA margins improved by 60 basis points, mainly driven by organic growth in collection and disposal and SG&A optimization.
Furthermore, during the earnings call, John Morris, EVP, and COO, highlighted WM's commitment to maximizing customer lifetime value, which has led to a decrease in churn to 8.3% in the second quarter.
This improvement in churn has enabled the company to convert more core price into yield, increasing the full-year outlook for collection and disposal yield to over 5.5%.
In terms of volumes, collection, and disposal volume grew slightly by 0.2%.
While the landfill business saw favorable volume growth, collection volumes were down modestly due to intentional pricing strategies to ensure acceptable returns and the impact of lower volumes from temporary roll-off.
Having said this, volume and commodity price headwinds are not unexpected, as economic growth indicators have hinted at contraction for more than eight months.
It's also good news for investors who are looking for an entry.
- Since early 2022, WM shares have been going sideways.
- WM shares are 10% below their 52-week high.
With regard to its valuation, WM shares are fairly valued at 14.5x LTM EBITDA and 13.7x NTM EBITDA.
Looking at the numbers below, we see that the company's EBITDA growth is expected to increase to 8.0% in 2024 and 8.1% in 2025. This lets me believe that a 14x multiple is warranted, giving the stock between 22% and 25% upside over the next 24 months - theoretically speaking.
However, given my view on the economy, I believe that WM shares could see a bit more downside.
While I will give WM a Buy rating based on its ability to generate value and valuation, I do not rule out a potential stock price decline to $150.
I believe that WM shares are a good buy between $140 and $150 (and everything below).
The consensus price target is $180, which is 13% above the current price.
If WM shares drop to my target area, I will likely be a buyer, depending on other opportunities in my watchlist and economic developments.
The bottom line is that I believe in WM's ability to generate tremendous long-term shareholder value with a low-risk business model.
It truly doesn't get much better than WM.
Takeaway
Despite my hesitation to buy more industrial stocks, WM is a terrific low-risk opportunity. With its enviable Buffett-style traits-defensive model, sturdy revenue, entry barriers, and sound balance sheet-it's a gem on my watchlist.
The company's landfill network secures its future, giving it a substantial moat.
Plus, WM's innovative initiatives, from renewable energy to consistent cash flow, reassure its potential.
A steady dividend growth record, resilient balance sheet, and favorable free cash flow prospects elevate its attractiveness.
Despite a modest yield, the trajectory and safety of its dividend growth is promising.
Valuation-wise, WM appears fairly priced, with room for further growth.
Although I expect a dip, a Buy rating is warranted, with $140-$150 as an attractive entry range.
As WM continues to paint a picture of low-risk, high-reward investment, I stand ready to seize any potential opportunities.
WM is, without a doubt, a true total return champion with a very favorable risk/reward profile.
Reasons To Be Bullish
- Robust Business Model : Waste Management boasts stable revenue streams and anti-cyclical demand, supported by a vast landfill network and competitive moat.
- Consistent Performance : WM has consistently outperformed the S&P 500 over the last five years.
- Strong Financials : With a solid balance sheet, manageable leverage, and credit ratings, WM is well-positioned for growth and financial stability.
- Innovative Initiatives : The company's efforts to convert waste into energy and expand revenue sources contribute to both environmental sustainability and business resilience.
- Dividend Growth : WM offers a history of dividend growth backed by prudent payout ratios and projected free cash flow growth.
For further details see:
Waste Management Is A Superior Dividend Stock - I Want In