Summary
- Waste Management is a Dividend Contender with 18 consecutive years of dividend growth. Shares currently yield 1.53%.
- Waste Management has unmatched scale in the waste collection and disposal industry with 260 landfills, 15,500 collection routes and 96 MRFs (recycling) facilities.
- Waste Management is vertically integrated handling everything from picking up the trash from the curb to disposal at a landfill and even generating power from the landfills.
Waste Management (WM) is the largest waste collection and disposal operator with dominant positions in the United States and Canada. Waste Management focuses on large urban/suburban areas where they can display dominance by utilizing their landfills, transfer and recycling facilities from their 15,500 collection routes.
Waste Management has a diverse revenue mix including commercial, industrial, and residential waste collection. Waste Management also owns 260 active landfills where they are able to charge other waste collection companies fees to access those landfills. The landfills have a huge NIMBY moat around them as you'd be hard pressed to find people that are clamoring for a new one for the sake of competition.
Waste Management also has roughly 75% of revenue that is recurring and stable from year to year. Especially on the collection side as many people don't have an option as the area is serviced by likely just one localized monopoly for collection and disposal.
I'm quite intrigued by the LFG and RNG projects in which Waste Management is able to generate energy from the decomposition of materials in their landfills. It's another revenue source that's layered on top of an existing landfill asset. If the project return forecasts are met then new RNG plants can offer ~$400 M in additional annual EBITDA from ~$825 M in total capex spend.
Waste Management is a wonderful business that I believe should continue to do well in the future. The question of course comes down to whether the valuation makes sense at this time to purchase shares.
Dividend History
The majority of my investments are based on the dividend growth investment strategy. That means that I want to find quality businesses that have a history of paying and growing their dividend over time. The hard part is being patient enough to buy when the valuation is reasonable and then just let the business work its magic over time.
Waste Management is a Dividend Contender with 18 consecutive years of dividend growth. Waste Management's dividend record got off to a bit of a rocky start with intermittent payment; however, beginning in 2004 dividend growth has come each and every year.
Dating back to 2004 year over year dividend growth from Waste Management has ranged from 2.7% to 13.0% with an average of 7.2% and a median of 7.0%.
Over that same time there's been 14 rolling 5-year periods with annualized dividend growth spanning between 3.7% to 9.5% with an average and median of 6.7%.
There's also been 9 rolling 10-year periods during Waste Management's dividend growth streak with annualized dividend growth coming in between 5.4% to 7.2% with an average of 6.1% and a median of 5.9%.
The rolling 1-, 3-, 5-, and 10-year annualized dividend growth rates from Waste Management since 2004 can be found in the following table.
Year | Annual Dividend | 1 Year | 3 Year | 5 Year | 10 Year |
2004 | $0.75 | ||||
2005 | $0.80 | 6.67% | |||
2006 | $0.88 | 10.00% | |||
2007 | $0.96 | 9.09% | 8.58% | ||
2008 | $1.08 | 12.50% | 10.52% | ||
2009 | $1.16 | 7.41% | 9.65% | 9.11% | |
2010 | $1.26 | 8.62% | 9.49% | 9.51% | |
2011 | $1.36 | 7.94% | 7.99% | 9.10% | |
2012 | $1.42 | 4.41% | 6.97% | 8.14% | |
2013 | $1.46 | 2.82% | 5.03% | 6.21% | |
2014 | $1.50 | 2.74% | 3.32% | 5.28% | 7.18% |
2015 | $1.54 | 2.67% | 2.74% | 4.10% | 6.77% |
2016 | $1.64 | 6.49% | 3.95% | 3.82% | 6.42% |
2017 | $1.70 | 3.66% | 4.26% | 3.66% | 5.88% |
2018 | $1.86 | 9.41% | 6.50% | 4.96% | 5.59% |
2019 | $2.05 | 10.22% | 7.72% | 6.45% | 5.86% |
2020 | $2.18 | 6.34% | 8.64% | 7.20% | 5.64% |
2021 | $2.30 | 5.50% | 7.33% | 7.00% | 5.39% |
2022 | $2.60 | 13.04% | 8.24% | 8.87% | 6.24% |
For dividend growth investors the dividend payout ratio is high on the list of metrics to track for a company. The payout ratio lets you know how much of the earnings or free cash flow of the business is paid out as dividends. All else being equal, the lower the payout ratio the better as there is more cushion for the inevitable disruptions or temporary issues as well as the possibility for dividend growth to exceed the growth of the underlying business.
Excluding FY 2013, Waste Management's net income payout ratio has averaged 59.5% over the last decade with a 5-year average of 49.6%. Waste Management's free cash flow payout ratio has average 52.2% over the last decade with a 44.5% average for the most recent 5-years. Waste Management's dividend is well-covered by both net income and free cash flow especially in light of the relatively stable nature of the underlying business.
Quantitative Quality
A lengthy dividend growth history is just one factor that I want the businesses that I own to have. There's a variety of other financial metrics that I track in order to get a handle on and a feel for the quality of the business.
Waste Management's revenues increased by just 31.4% in total over the last decade or ~3.1% annualized. Gross profits fared better rising 43.0% in total or 4.1% annualized.
Waste Management has done a much better job improving profitability further down the financial statements. Operating profits increased by 60.2% or 5.4% annualized with operating cash flow improving by 89.0% or 7.3% annualized. Free cash flow showed tremendous improvement rising by 210.1% in total over that time or 13.4% annualized.
My expectation is that a strong business will be able to maintain their margins at a minimum and preferably show rising margins over time. Ideally I want to see free cash flow margins of at least 10%; however, the trajectory plays a bigger role in whether I'm interested.
Waste Management carries relatively low gross margins; however, they have been steadily improving during the last decade. The 10-year average gross margin is 37.1% with the 5-year average coming to 38.2%.
Waste Management has shown tremendous improvement in their free cash flow margin over that time and has surpassed the 10% level for the last 6 years. The 10-year average free cash flow margin works out to 10.7% with the 5-year average sitting at 12.5%.
Additionally I monitor how efficient the business is with generating free cash flow from its asset and capital base. The free cash flow return on invested capital, FCF ROIC, represents the amount of free cash flow that the business generates compared to the current invested capital. I prefer to see a stable FCF ROIC over time and preferably increasing as the business is able to become more efficient or invest in higher return projects.
Waste Management has been able to improve across the free cash flow returns across the board during the last decade. The FCF ROA has averaged 6.6% for the last decade with a 5-year average of 7.5%. Waste Management's FCF ROIC has averages of 9.2% and 10.5%, respectively.
The FCF return on tangible capital, FCF ROTC, attempts to narrow down just the physical capital that is required to run the business. Waste Management has shown strong improvement on this metric during the last decade as well with the 10-year average coming to 13.0% and the 5-year average working out to 15.0%.
To understand how Waste Management uses its free cash flow I calculate three variations of the metric, defined below:
- Free Cash Flow, FCF: Operating cash flow less capital expenditures
- Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
- Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less net cash used on repurchasing shares
Over the last decade, Waste Management has generated a total of $15.8 B in FCF. Waste Management has also paid out a total of $7.8 B to shareholders in dividends which puts the cumulative FCFaD at a very strong $8.1 B. Waste Management has also spent a net total of $5.4 B on share repurchases which brings the cumulative FCFaDB for the last decade at $2.7 B.
From a capital return standpoint Waste Management prefers dividends to share repurchases. Over the last decade Waste Management has spent roughly $1.44 in dividends for every $1.00 used on share repurchases.
Share repurchases can be a great way for management teams to return excess cash flow to owners without the full-on commitment that a higher baseline dividend requires. Most shareholders wouldn't balk at a reduction or outright stoppage of share repurchases; however, if the dividend is cut that would leave a very foul taste in investors' mouths.
From the end of FY 2012 through the end of FY 2021 Waste Management's share count has fallen by 8.9% or approximately 1.0% annualized. It has been a fairly steady decline over that time with the largest year over year decline being 2.2% for FY 2018 versus FY 2017. However, despite significantly more cash allocated to buybacks in FY 2021 the share count only fell by 0.5% due most likely to the rich valuation that Waste Management has traded at recently.
When I invest my savings into a business my intention is to own that stake for years at a time while letting the business work its magic. As such I want to make sure that the business doesn't appear to be excessively leveraged potentially putting my equity investment at risk.
In terms of its capital structure, Waste Management has maintained roughly a 2:1 ratio between debt and equity with no significant deviations. The 10-year average debt-to-capitalization ratio is 63% with the 5-year average coming to 64%.
Additionally, I monitor the net debt ratios over time to see how much leverage is placed on the profits and cash flows of the business. The net debt ratios give a better idea of how much debt is layered on top of the business as well as its ability to pay down or service the debt.
Waste Management carries a healthy amount of debt in comparison to its cash flows; however, given the relatively stable nature of its business they can afford to use more debt than businesses that are more variable.
The 10-year average net debt-to-EBITDA, net debt-to-operating income, and net debt-to-FCF ratios for Waste Management are 2.8x, 4.7x, and 6.9x, respectively. The 5-year averages work out to 2.6x, 4.2x, and 5.8x, accordingly.
Additionally the interest coverage ratio for Waste Management has been improving over time thanks to lower overall interest rates on the debt that is carried.
Valuation
When attempting to value a business, I employ several valuation methods that attempt to value the business from multiple vantage points. The methods that I use are dividend yield theory, a reverse discounted cash flow analysis, and a minimum acceptable rate of return, "MARR", analysis.
Dividend yield theory is a valuation method that's based around reversion to the mean over time. The idea being that a business will be valued around a normal dividend yield. For Waste Management I'll use the 5-year average forward dividend yield as a proxy for fair value.
Since around 2013, Waste Management has rarely approached the 10% or 20% undervalued band based on dividend yield theory hitting those marks during the depths of the pandemic selloff. Over that time the forward dividend yield that investors have been willing to accept from Waste Management has been steadily falling.
The 5-year average forward dividend yield sits at 1.76% while shares currently offer a forward dividend yield of 1.54%.
A reverse discounted cash flow analysis can be used to reverse engineer what the current market valuation implies about the future growth, margins, and free cash flow the business must generate. In other words it's a way to find out what you have to believe the business can produce in order to justify the current pricing offered in the market.
I use a simplified DCF model built on revenue growth, an initial free cash flow margin of 11.9% that improves to 14.0% during the forecast period. The terminal growth rate is assumed to be 2.5%.
For the discount rate I've used an after-tax cost of debt of 2.66% in conjunction with a 10% and 8% cost of equity. That yields a discount rate of 8.8% for the 10% cost of equity scenario and 7.2% for the 8% cost of equity scenario.
Under those assumptions Waste Management needs to grow revenues 12.8% annually through the forecast period in order to generate the free cash flows that would support a 10% cost of equity/8.8% discount rate. With the 8% cost of equity/7.2% discount rate the required revenue growth drops to 8.0% annually through the forecast period.
The MARR analysis requires you to estimate the growth in earnings and dividends that a business will achieve over a given period of time. You then apply what you believe to be a reasonable and conservative terminal multiple that shares will trade at in the future and calculate the expected return. If the expected return is less than your minimum return threshold for investment then you hold off until the valuation comes down and the expected return rises.
Analysts expect Waste Management to show $5.72 EPS for FY 2022 and $6.39 for FY 2023. They also expect Waste Management to be able to grow earnings 9.25% annually over the next 5 years. I then assumed that EPS growth would slow to 6.0% annually for the following 5 years. Dividends are assumed to target a 45% payout ratio.
When trying to determine an expected terminal multiple I like to see how investors have typically value Waste Management over time. During the last 10 years Waste Management has usually traded between ~15x and 30x TTM EPS.
The following table shows the potential internal rates of return that Waste Management could generate if the assumptions laid out above prove to be reasonable forecasts. Returns assume that dividends are paid and raised along the timeline that Waste Management has usually followed and that all dividends are taken in cash. Returns also assume that shares are purchased at $170.04, Thursday's closing price.
IRR | ||
P/E Level | 5 Year | 10 Year |
30 | 12.6% | 10.1% |
25 | 8.2% | 8.1% |
22.5 | 5.7% | 7.0% |
20 | 3.0% | 5.8% |
17.5 | 0.0% | 4.4% |
15 | -3.3% | 2.9% |
Source: Author
Additionally I use the MARR analysis framework to reverse engineer the maximum price I could pay for shares today across the multiple range such that I would generate the returns that I desire from my investments. My standard hurdle rate is a 10% IRR and for Waste Management I'll also examine 12% and 8% return thresholds.
Purchase Price Targets | ||||||
10% Return Target | 12% Return Target | 8% Return Target | ||||
P/E Level | 5 Year | 10 Year | 5 Year | 10 Year | 5 Year | 10 Year |
30 | $188 | $171 | $175 | $147 | $203 | $200 |
25 | $159 | $147 | $147 | $126 | $171 | $172 |
22.5 | $144 | $135 | $134 | $116 | $156 | $157 |
20 | $130 | $122 | $120 | $105 | $140 | $143 |
17.5 | $115 | $110 | $107 | $95 | $124 | $128 |
15 | $100 | $98 | $93 | $85 | $108 | $114 |
Source: Author
How Did We Get Here?
Stock prices and returns obviously fluctuate; however, it's important to see how they compare with the underlying business results. Waste Management has been an excellent investment.
Between December 31, 2012 and December 31, 2021, Waste Management's share price has increased by 394.7%. That's a remarkable 17.3% CAGR, exclusive of the initial 4.2% dividend yield, for a relatively staid and mature business. To say the returns have been fantastic would be an understatement.
Of course, returns are brought about by both business fundamentals and growth as well as the changes to investors' psychology. I want break down the returns over time to try and separate out business results justified returns as well as the change in investors' mood.
This section tries to breakdown how the returns have come over the last decade using the FY 2012 and FY 2021 business results in conjunction with the closing prices as of the end of each fiscal year.
Between the end of FY 2012 and FY 2021 sales growth accounted for ~3.1% annualized returns with margin improvement adding 6.0% annually. As we saw earlier share repurchases added roughly 1.0% annually to your returns. Multiple expansion has done the heavy lifting as far as return attribution as the P/E multiple rose from 19.2x at the end of FY 2012 up to 38.9x at the end of FY 2021 adding roughly 7.3% to your annualized returns.
In other words, the business justified returns accounted for roughly 9.1% annualized returns with the capital allocation justified returns providing ~5.2% annualized over that time. Meanwhile investors' mood added 7.3% annually.
No doubt the business results as well as the capital allocation returns were strong and warranted ~14.2% annualized returns during that period or roughly 2/3 of the annualized returns. However, investors' mood provided around 1/3 of the annualized returns which I wouldn't bank on repeating moving forward.
Conclusion
Waste Management is a fantastic business that is built for success over the long term. It's a boring, dirty business; however, that doesn't mean that investment results are disappointing.
Despite modest revenue growth over the last decade, ~3.1% annually, Waste Management has been able to translate that into 10.4% annual EPS growth thanks to margin improvement and share repurchases.
Waste Management carries strong free cash flow margins that have now been greater than 10% for each of the last 6 years as well as the TTM period. They don't carry as strong of cash flow returns as I would have expected; however, they are trending in higher over time.
The best part about Waste Management is that the business is very predictable. I know I don't want trash piling up at my house so I'm effectively willing to pay whatever it takes for them to pick it up and haul it off. I can't imagine I'm the only one that feels that way.
Dividend yield theory suggests a fair value range of $126 to $154 and with the shares currently trading around $170 it appears overvalued.
The MARR analysis also shows that shares are likely overvalued at current prices. Based on a 17.5x to 22.5x terminal multiple 5 years out and a 10% return target, the fair value range comes to $115 to $144. Reducing the return target to just 8% raises the fair value range to between $124 to $156.
Similarly, the reverse DCF analysis suggests that Waste Management is quite expensive at the current share price around $170. In order for Waste Management to able to justify the current market valuation requires very optimistic revenue growth assumptions as well as a pretty strong improvement in free cash flow margins.
While I like Waste Management the business, the valuation is just too rich for me at the current price around $170 and I would expect returns to be more muted over the coming decade for investors that purchase around these levels.
From the "how did we get here" section even if we assume the following decade sees the same justified annualized returns from sales, margins and share count with the current 1.5% dividend yield gives a business justified return of around 11.6% annualized.
I think it'd be hard to find investors willing to bank on an additional 7.3% annualized return from multiple expansion over the coming decade to equal the CAGR from 2012 through 2021. In my opinion the best case scenario is that the multiple is around a 0.0% for the coming decade and is more likely to be a drag on returns especially if interest rates continue to rise.
The business is fantastic and I love the consistency. It's one of those boring, under-the-radar companies that just continues to do well for shareholders over time. The current share price is a high price to pay for a quality, defensive business that has very little disruption risk.
I regrettably missed out on purchasing shares of Waste Management during the chaos that was 2020. Earlier this year it's twice reached levels where I would feel comfortable adding, but unfortunately the starts weren't aligned such that I had cash available to make a purchase. For now I'll continue to sit on the sidelines and patiently wait for an opportunity to buy shares of Waste Management at better valuations.
For further details see:
Waste Management: Trash Is Cash