2023-09-19 12:08:18 ET
Summary
- Waste Management's renewable natural gas segment has seen outstanding growth and is expected to continue growing with the opening of 20 new facilities.
- The company is implementing cost-cutting measures to improve efficiency and profitability.
- Waste Management's financials show a good company with a decent moat and competitive advantage.
Investment Thesis
Waste Management's ( WM ) operations are running smoothly, and with a very promising renewable natural gas segment that has seen tremendous growth in the last couple of years, coupled with more facilities being built to accommodate further growth, the company has a lot of potential to perform well in the future. However, I would like to see a pullback before starting a position, as risk/reward is not as enticing right now.
Outlook
The company’s most promising venture these days is the renewable natural gas segment or RNG. In their latest quarterly transcript , the management is focusing its energy on opening 20 facilities that will facilitate the growth of this segment for many years to come. This is a big deal because already, this segment, which is under the "other" revenue segment has seen outstanding growth in the last few years, growing at around 22% CAGR. An analyst at HSBC recently gave his thoughts on WM and praised the initiatives in the RNG sector, which he said will add 6 percentage points to its earnings CAGR.
Another initiative that will certainly help the company become more valuable is the cost-cutting measures that the management is taking, which will reduce labor costs per ton and total operating costs per ton. In the management's words:
In the second quarter, our fully automated recycling facilities delivered differentiated results relative to the rest of the network with 33% lower labor cost per ton and 18% lower total operating cost per ton.
I tend to believe that over time, as technology improves, companies tend to become more efficient and profitable, and WM is not different here. I would like to see WM’s cost-cutting measures succeed, which will lead to better earnings growth in the long run. Better than what is already assumed according to analysts, but we will have to wait and see how these develop with time.
Financials
As of Q2 ’23 , WM had $144m in cash against $14.8B in long-term debt. That is a good chunk of debt on the books, however, is it a problem? Historically the interest coverage ratio has been around 9x as of FY22, while in the 6 months ended June of this year, that ratio stood at around 7x, so it has gotten a little worse, but it is not a problem in my opinion. Most of the debt is variable interest debt, so it is exposed to fluctuations in the interest rate, however, I believe we’ve seen the worst of it already and I would expect the interest rate to come down over the next couple of years. On top of that, a healthy interest coverage ratio is considered to be 2x, while I like to see at least 5x. So, in my opinion, debt is not an issue here and the company is at no risk of insolvency as EBIT can cover the interest expense on debt 7 times over.
The company’s current ratio has been at the lower end for the last 5 years and it is well below my requirements of at least 1.5-2.0. As of FY22 and Q2 ’23, the company’s current ratio stood at around .82, which means it doesn’t have enough liquidity to cover its short-term obligations. This could be an issue if all the obligations were due at the same time, however, seeing that the company has been operating with such a ratio for a while now, I don’t think it’s going to be a problem in the future either, so I would say the company has no liquidity issues for now, but it is something to pay attention to.
The company’s ROA and ROE have been quite decent over the last 5 years at least and are well above my minimum of 5% for ROA and 10% for ROE. This tells me that the company is being efficient with its assets and shareholder equity and is creating value.
The return on invested capital or ROIC is also quite decent and above my minimum of 10%, which tells me the company has a decent competitive advantage and a decent moat. I am willing to pay a slight premium if a company manages to achieve over 10% ROIC.
In terms of revenues, the company hasn’t been growing spectacularly in the last decade, however, the “other” segment, which includes the gas-to-energy revenues has grown at around 22% CAGR from FY22, so that is something to consider when assuming the growth of total revenues in the future.
In terms of margins, the company kept them consistent over the years, which is great. Can the company improve them in the long run? That is a question that cannot be accurately answered, however, I do believe that with time, companies do tend to become more efficient as technologies improve, and judging from the comments from the management earlier, I could see these improving slightly over time.
Overall, the company seems to be running like a well-oiled machine that has a competitive advantage, a strong moat, and is creating value for all the parties involved. The only gripe I may have with the financials is the company’s subpar current ratio. I would like to see this rectified in the future.
Valuation
For the revenue growth for the base case, I decided to go with around 7% CAGR for the next decade, which is slightly on the optimistic side, however, as I mentioned above, the "Other" segment has seen tremendous growth in the last few years and given further investments in that segment, I could see this growth persisting a little while longer, which warrants my long-term growth assumption in my opinion.
For the optimistic case, I went with around 11% CAGR over the next decade, while for the conservative case, I went with around 5% CAGR for the same period to give myself a range of possible outcomes.
In terms of margins, I also decided to be a little bit more optimistic, and I assumed that over the next decade, gross margins will see an improvement of around 3% from FY22 while operating margins will see around 2% improvement. This will lead to net margins improving from 11% in FY22 to around 17%.
I believe these assumptions are achievable for a company like WM, which is a leader in the sector, with a strong moat, and decent outlook.
I will add a 15% margin of safety to the final calculation, just to give myself a bit of a cushion and a better risk/reward outcome if I were to invest in the company. With that said, Waste Management’s intrinsic value is around $141 a share, which means that the company is trading at a slight premium to its fair value in my opinion and a pullback would be nice.
Closing Comments and Investor Takeaway
I believe that the company is a little too expensive right now, given the revenue growth it does not look like it's going to improve going forward very much unless the "other" segment continues to surprise. The company is trading at quite a high FWD P/E ratio, and the only reason I believe that it is trading so high is because it's a company that is quite safe with very little volatility, which attracts investors that look for a good night's sleep. It also seems to be struggling to break that $175 price, as it tested it about 6 times in the last 5 years, so I would be hesitant for now as it may pull back quite a bit. I would like to see the company pull back towards my risk/reward profile of $141 as I like the company there much more. I believe the company is very stable in the long run and will continue to perform well.
I would like to see the renewable natural gas segment continue to perform at the same levels for awhile, which would improve the company's revenue outlook tremendously if the new facilities that the company is building will pay off in the long run.
The company’s option chain doesn’t have a lot of implied volatility, which means that selling Cash-secured puts at around $141 strike price wouldn’t get you much in terms of premium. If the company comes closer to my PT, then it may become more profitable. You can get paid while it hits that strike price, and you enter into a position on a lower-cost basis.
For further details see:
Why Waste Management Is Not An Investment Yet At This Price