Buy Waste Management: Benefit From Excellent Capital Appreciation And Dividend Hike

| About: Waste Management, (WM)

Waste Management (NYSE:WM) has been one of the most neglected stocks in the industrials sector. When it comes to the dividend-paying stocks, I hear the investors talking about the Lockheed Martins (NYSE:LMT), Boeings (NYSE:BA) and General Electrics (NYSE:GE) of the Industrial world. However, only a few talk about WM which has a dividend yield of 4.24%, more than that of GE and BA. Yesterday, Goldman Sachs upgraded this stock to buy from hold and increased the target price from $33 to $42.

Apart from a high-dividend yield (considering that it is an industrial stock), I believe that the stock has a massive potential for capital appreciation. There are multiple catalysts on the horizon that are expected to push up the stock price:

  1. A continued recovery in the Residential Fixed Investment (RFI) (discussed in detail below)
  2. A strong uptick in the Municipal Solid Waste (MSW) volumes brought by the US housing recovery
  3. An improvement in the MSW pricing
  4. An improvement in the old corrugated container (OCC) prices

A Recovery in the RFI and the Housing Sector

The US RFI is a strong driver of the MSW volumes. The following graph shows the historical patterns for both the factors and indicates the underlying strong correlation between them.

GS claims that the coefficient of determination (R-squared) between the RFI and the MSW volume is a significant 0.81. Using this, we can calculate the coefficient of correlation to be 0.9 (simply the square root of 0.81) which is quite high. Also, the historical trend shows us that the correlation between the MSW volumes and the RFI is the highest when the RFI is lagged by two quarters. This means that the MSW volumes do not react instantly to a rise/decline in the RFI. Some lag time is involved. Therefore, the sensitivity of MSW volume to a change in RFI is the maximum when the lag time is close to two quarters.

As the graph shows, the RFI has recently picked up. This time around, GS expects the lag time to be around two months, i.e. a pick-up in the RFI will translate into higher MSW volumes after a two quarter lag. The US RFI is expected to increase 12.9% and 14.8% in 2013 and 2014 which will lead to a rise of 2% and 2.8% in the MSW volumes respectively.

The following chart shows the source of MSW generation:

Source: EPA

The construction and demolition (a part of yard trimmings) is hardly 10-12% of the overall MSW stream. However, I still believe that the C&D waste will be a key growth driver of the MSW volumes given that a significant part of the MSW stream exhibits stable growth and is little correlated to the economic activity. Therefore, the housing recovery in the US is expected to bring an improvement in the waste volumes.

An improvement in the MSW pricing:

Mostly, the pricing for this industry has remained above the inflation rate. However, the pricing for this industry has slipped from a very attractive 4% above the inflation rate in 2007 to 1% (above the CPI index) in 2012. The slip in pricing can be attributed to the construction downturn in the 2009-2011 time period and the intense competitive pricing environment in the waste industry. However, the increase in the MSW volumes is expected to ramp up the prices in the near-future. The sell-side expects the prices to rise to 3% (above the CPI index).

A potential cyclical recovery in the OCC prices:

The waste management companies derive 10% of their revenues from recycling. A change in the old corrugated container price is a good proxy for a change in the revenue/profit in the recycling business. The demand from China is a key driver of OCC prices. The sequential drop in the Chinese industrial production (displayed by the Purchasing Managers' Index) has led to a 43% decline in the OCC prices since 2011. However, an improvement in the Chinese industrial production rate is expected in 2013 which should push up the prices of OCC.

The following graph shows how the earnings of different players in the waste management industry are affected by a change in the price of OCC:

The graph shows that the sensitivity (to a $10/ton change in the price of OCC) of the EPS of WM is the greatest in the industry followed by the EPS sensitivity of Republic Services (NYSE:RSG) and Waste Connections (NYSE:WCN). Goldman Sachs predicts that the price of OCC will be $117/ton in 2013. This means a rise of $0.012 in the EPS of WM, given that the current price of OCC is $114/ton. OCC prices are expected to rise through 2015.

Dividend and Valuations

The stock is currently trading at a forward multiple of 14x. The target price set by GS is $42 which means a capital appreciation of 25% from the current price level. The stock pays an attractive dividend yield of 4.24% which is higher than most of the stocks in the Dow Jones and the Industrials sector. From time to time, the company has been buying back its shares:

Also, the company has been increasing its dividends on a regular basis.

A pretty insightful article has already been written on this stock which has covered the dividend perspective in detail. Therefore, I will not go in much detail. However, I believe that given the forecasted increase in the revenues for WM, the investors can also expect a dividend hike in the near-future.

Given, the current growth story in the stock, I will recommend the stock as a buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.