2023-07-20 08:02:14 ET
Summary
- Based on the Q1 financial performance and the improving macroeconomic landscape, we expect Waste Management to deliver improved results in Q2, primarily driven by lower costs.
- Our updated dividend discount model, using different discount rates and dividend growth rates still indicates that WM is trading at a significant premium.
- Despite this, the company's stock is not considered a "sell" due to its robust business even in a volatile market environment.
- For these reasons, we maintain our "hold" rating.
Waste Management, Inc., ( WM ) through its subsidiaries, provides waste management environmental services to residential, commercial, industrial, and municipal customers in North America.
So far, we have published two article about Waste Management on Seeking Alpha. We started our coverage mid-2022 with a "buy" rating, citing the firm's relative independence of the consumer sentiment, consumer spending and in general the investment's defensive nature. We have also found the firm's dividends and share buybacks attractive at the time. In Q3 2022, we have become somewhat more cautious, primarily due to the company's valuation. Based on the Gordon Growth Model - a single stage dividend growth model - we have seen limited upside from those price levels. The traditional price multiples have been also indicating that the upside may be limited.
Today we have decided to revisit WM's stock and give an update on our previous thesis. We will begin our writing by looking at the Q1 financial results and formulate our expectations about how Q2 earnings might look like. Then we will provide an update to our valuation model, incorporating the most recent changes in the macroeconomic environment.
Review of Q1 results and expectations for Q2
Although the Q1 results have been reported already months ago, it is important to briefly recap these results and see what impact they may have on our valuation model and what expectations we can form about Q2, based on these figures.
Short recap:
- The firm's organic revenue growth in the collection and disposal business has reached 7.0% in Q1 2023.
- Total Company volumes increased 1.2%, or 0.9% on a workday adjusted basis, which represents a meaningful decline compared to the 3.6% in the first quarter of 2022.
- Operating expenses as a percentage of revenue increased 80 basis points to 63.1%, resulting in an operating margin contraction. This negative development has been primarily fuelled by the wage increases, the impact of inflationary cost pressures on repair and maintenance and subcontractor costs, and margin dilutive impacts from recently closed acquisitions.
- SG&A expenses were 9.7% of revenue compared to 10.5%, or 10.1% on an adjusted basis. The improvement can be mainly attributed to the firm's successive initiatives in technology and automation. This development has slightly offset the negative impacts of the operating cost increases.
- Operating EBITDA in the Company's collection and disposal business, adjusted on the same basis as total Company operating EBITDA, was $1.5 billion, or 30.6% of revenue, for the first quarter of 2023, which has been an improvement year-over-year in absolute terms compared to $1.4 billion, but as a percentage of revenue we see a slight deterioration compared to the 31.3% of revenue in Q1 2022.
- The free cash flow figure in the first quarter has also showed some deterioration compared to the prior year mainly because of the higher CAPEX related to sustainability growth investments and the timing of collection vehicle deliveries, increased cash interest, and higher incentive compensation payments.
Q1 results (WM)
So based on these facts, what do we expect or what would we like to see in the Q2 results?
We are not concerned about the revenue side of the business as WM is providing essential services, which are likely to remain in demand irrespective of the macroeconomic environment. The firm has also a certain pricing power, which allows it to adjust the pricing when necessary.
We are more focused on the cost side of the results. We would like to see the effective cost management continue and management delivering on its promises related to permanent cost reductions driven by technology and automation. In our opinion, it is highly likely that many components of the expenditures will improve on a year-over-year basis, due to the improving macroeconomic environment. Inflation, although still elevated, has eased significantly compared to the prior year. Energy cost, fuel cost and raw material costs have also declined substantially, potentially resulting in improved margins compared to the prior year.
An analyst at Stifel has also has updated its rating on WM from "hold" to "buy", but citing slightly different reasons:
[...] the biggest landfill operator in North America by revenue is poised to benefit from a recovery in commodities prices. [...] Waste Management's ((WM)) sources of income include the sales of biomethane from decomposing waste. The energy source is known as a renewable natural gas because it's collected from organic sources and can substitute fossil fuels.
Further, we also would like to see free cash flow generation improving. The firm has been spending substantial sums on the sustainability growth investments, which have resulted in increased CAPEX and therefore in lower free cash flow. Also important to mention here that the free cash flow has a great influence on the ability of a firm to pay its dividends. Despite the reduced free cash flow in the previous quarter, WM had still more than enough money left to cover the dividends.
All in all, we would like to see the firm's margins expanding and costs falling, which could well be fuelled by the improvement of the macroeconomic environment compared to 2022.
Valuation update
In our previous writing , we have estimated a very wide range of fair values, between $60 and $180, based on perpetual dividend growth rates of 3% to 6% and a discount rate of 7.5% - equivalent to the firm's weighted average cost of capital.
Today, we will be using a similar approach, but updating our input parameters by taking the most recent macro- and microeconomic developments into account.
Discount rate
We will once again base our discount rate on the weighted average cost of capital. However, as the macroeconomic environment changes and interest rates increase, the cost of capital also changes. According to the latest estimates, the firm's WACC is 9.25%, meaningfully higher than the previously used 7.5%. Implementing this higher discount rate will have a severe impact on our valuation.
Dividend growth in perpetuity
As mentioned earlier, despite the decline in free cash flow year-over-year, the firm still has the ability to sustain its dividends and even buy back shares. The most recent announcement of dividend payment has been made in May, declaring a $0.7 per share quarterly dividend, in-line with the previous. This is equivalent to an annual yield of 1.6%.
Now, if we use our previous approach, we get a range of fair value between $43 and $79 per share, which we believe is unreasonably low.
These results do not consider potential near term revenue and earnings growth as a result of the firm's growth initiatives and also does not directly take into account the positive impacts of the share buyback programs. The high weighted average cost of capital also ignores that interest rates are not likely to remain at these elevated levels forever.
To come up with a more meaningful estimate, we have decided to use a multi-stage dividend discount model, assuming an initial high growth rate period (10%) for five years, and then a perpetual growth rate of 4%. We have also lowered our discount rate to account for the potential benefits of an improving interest rate environment.
These calculation result in a fair value of $111 per share, still significantly below the current market value.
Price multiples
It is not just our approach, however, which signals an overvaluation. The traditional price multiples are also indicating that the firm is trading at a significant premium compared to the industrials sector median. Although WM has been historically more expensive, in some instances it is also trading at a slight premium compared its own 5Y averages, which we believe is not justified in the current market environment.
Conclusion
In our opinion, WM remains a solid choice among dividend - and dividend growth investors, who are looking for a safe haven during a volatile market environment, as the dividends appear to remain safe and sustainable in the near term.
In Q2, we would like to see the firm's financial performance improving, especially from cost perspective, which can be driven by the improving macroeconomic environment, including moderating inflation and lower raw material prices.
In our view, the firm remains relatively overvalued compared to the industrials sectors and according to some price multiples, even to its own 5Y averages. Based on a multi-stage dividend discount model, our estimated fair value is $111 per share.
We do not believe that because of this overvaluation the stock is a "sell", as WM's business remains robust and in demand, irrespective of the consumer sentiment and the market environment. But at the current valuation, we see limited upside potential in the near term.
For these reasons, we maintain our cautious "hold" rating.
For further details see:
Waste Management: We See Limited Upside Potential At The Current Price Levels