2024-01-04 13:16:52 ET
Summary
- Waste Management is the largest environmental solutions provider in North America, and it continues to improve its competitive position.
- The company generates strong free cash flow, but we expect the measure to face headwinds from sustainability spending. Still, we think its 2027 targets for free cash flow are achievable.
- Waste Management's return on invested capital is above its cost of capital, indicating excellent value creation. We're huge fans of the value it continues to generate for shareholders.
- The market is on to this idea, and we view shares as fully valued. However, the company's dividend growth potential remains robust, in our view.
By Valuentum Analysts
We last wrote about Waste Management ( WM ) in September 2022 in this article , and much of our thesis continues to ring true. The firm remains an income-generation gem, and our forecasts for its dividend growth remain strong. Shares yield ~1.6% at this time. The company retains one of the "moat-iest" (competitively-advantaged) business models around, thanks to the substantial pricing power it has within its disposal operations.
Trash, after all, must go somewhere, and those that own the final destination often have tremendous pricing flexibility with a bias upward over time, often well in excess of the pace of inflation. We continue to believe that Waste Management will deliver when it comes to long-term dividend growth, though we note that the firm's spending on sustainability initiatives will inevitably pressure its free cash flow growth potential in the near term.
For those not familiar with Waste Management, the company is the largest waste management solutions provider in North America. It serves millions of customers through a network of recycling facilities, transfer stations, waste landfills, and landfill gas energy facilities. We like that Waste Management’s asset base is quite diverse, and its landfill operations are the most attractive, as they boast significant barriers to entry.
Regulatory requirements and stiff NIMBY (Not-in-My-Back-Yard) opposition are two reasons why these assets will only become more valuable in time. Though volatile commodity prices can cause large swings in its recycling-related revenues and commercial and industrial revenue may ebb and flow with the economic cycle to a degree, the collection side of its residential business is generally stable and can be viewed as largely recession-resistant.
Free Cash Flow Generation Remains Key
Waste Management's trajectory of free cash flow remains strong, despite sustainability headwinds. (Waste Management)
Waste Management expects to continue to generate strong free cash flow, as shown in the image above, but sustainability spending will pose headwinds to the measure, at least in the near term. Free cash flow consistently remains one of the most attractive attributes of the waste services business model, and Waste Management is the poster child in this area. The company also generates impressive return on invested capital thanks to the high-quality nature of its earnings and disciplined investment practices. Its pricing strength at its recycling, collection and disposal businesses support its long-term outlook, and we expect return on invested capital to continue to increase in the years ahead.
We expect Waste Management's return on invested capital to continue to march higher in coming years. (Valuentum)
Based on our forecasts as it relates to our valuation model, we expect Waste Management's free cash flow will be ~$1.82 billion in 2023, ~$2.26 billion in 2024, and ~$2.94 billion in 2025. Helping with these targets for free cash flow generation are efforts to improve its cost structure going forward through a combination of technology investments and economies of scale, a strategy supported by its pricing strength.
These are solid numbers, for sure, but our estimates may look a bit low relative to management's expectations. Free cash flow was $1.48 million during the first nine months of the year , and management will have a lot of work to do to achieve $3.8-$4.2 billion in free cash flow by 2027. In any case, we estimate Waste Management will achieve that goal, as our estimate for 2027 stands higher than this range at ~$4.4 billion.
Waste Management has been a strong free cash flow generator. (Valuentum) We expect strong free cash flow growth at Waste Management in the coming years. (Valuentum)
Valuation
On the basis of our discounted cash flow [DCF] valuation model, we think Waste Management is worth $162 per share, lower than where shares are trading at the time of this writing ($180 per share). The market is building in a nice premium relative to Waste Management's DCF-derived valuation, in our view. We project a compound annual revenue growth rate of 5.1% during the next five years, which considers an implicit slowing in the economy in the next 12-18 months. We would expect that a decent percentage of our top-line growth assumptions will be driven by pricing initiatives. We forecast a 5-year projected average operating margin of 19.2%, as we expect price and cost take-outs to continue to bolster levels of profitability. Efficiency initiatives should continue to support the company's margins.
Our summary assumptions to derive our fair value estimate of Waste Management. (Valuentum)
The image below reveals that not much of the firm's total intrinsic value is derived in the near term, with most of its value attributed to mid-cycle and long-run assumptions, so we don't worry too much about differing from consensus in the next couple of years in the context of valuation. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.5% for the next 15 years and 3% in perpetuity, conservative but reasonable levels consistent with standard valuation practices. For Waste Management, we use an 8% weighted average cost of capital to discount future free cash flows, which is below average but warranted given Waste Management's lower-risk profile.
The build up and break down to our estimate of Waste Management's equity value. (Valuentum)
Dividend Health
During the past several years, Waste Management has increased its dividend at a high-single-digit pace, and the firm targets a 40-50% payout of free cash flow, implying significant dividend growth potential as we expect free cash flow measures to expand considerably in coming years. We're being conservative in our dividend growth forecasts, as we continue to assess the capital outflows related to the company's sustainability initiatives, but we expect at least a low-to-mid single-digit annual increase in the coming years.
Waste Management's business model is perhaps best suited for dividend growth, given the resilience of its free cash flow through the ups and downs of the economic cycle. We noted above that free cash flow was $1.48 million during the first nine months of 2023, and that easily covered cash dividends paid of $855 million over the same time period. The company truly has a lot of room to ramp its dividend payments, implying years and years of future dividend growth potential, in our view.
Concluding Thoughts
Waste Management's solid free cash flow generation provides the backbone behind its dividend growth story. The firm's ~1.6% dividend yield isn't as exciting as some other high yielders, but the consistency of its operations through thick and thin make it a staple for most dividend growth portfolios. We may be conservative in our forecasts of dividend growth at Waste Management given the intensity of the capital outlays regarding its sustainability initiatives, but few business models are as attractive as that of Waste Management. When it comes to long-term dividend growth potential, it's hard not to like Waste Management, in our view.
For further details see:
Waste Management's Dividend Growth Potential Remains Impressive