Waste Management: Promising Landfill-to-Energy Story

No industry is immune to the effects of this recession and environmental services / waste management companies are no exception. The refuse industry was once fragmented, but consolidation has narrowed the field.

The 800-pound gorilla by market cap is Waste Management (WMI), followed by Republic Services (RSG), and smaller players Waste Connections (WCN) and Casella Waste Systems (CWST). Garbage isn’t sexy, but tons of it is generated every day.

The trash business is very capital intensive but generates lots of cash flow. WMI and RSG both operate with an integrated business model including logistics, collection, transport, recycling, storage, disposal and related services.

Via its Wheelabrator Technologies unit, WMI is also a leader in (solid materials) waste-to-energy, operating 17 power plants capable of processing 24,000 tons of waste per day. In addition, WMI is the largest owner and operator of landfills. It is its foray into landfill gas-to-energy initiatives that we think offer tremendous potential going forward.

Permits to develop or expand landfills are difficult to obtain in our environmentally conscious society and WMI’s dominant footprint gives them a definite “supply” advantage. Yet, with nearly 300 sites managing the disposal of millions of tons of waste each year, it also provides the company with a vast supply of a naturally produced renewable energy source: methane gas. Currently, WMI operates two bio-reactor plants supplying enough methane to power 240,000 homes.

Leveraging its technological advantages with its strong market position could very well be a catalyst for sustainable future earnings growth. However, these projects don’t come cheap. If management can manage their costs and continue to generate operating cash-flow amidst a difficult economy, WMI’s prospects look very bright indeed.

We use an uncommon technique known as “dual cash flow” analysis to help us determine the earnings quality of a company. Unlike conventional cash-flow analysis, our model is tweaked to compare the cash-flows generated from actual operations to those produced by accounting adjustments in the balance sheet.

In the table above you can see the impact of this recession on WMI. Earnings and revenues have declined the previous three quarters. Changes in cost-of-goods sold, receivables (including DSO’s) and inventory are for the most part in line with sales.

Inventory as a % of sales increased slightly the past two quarters and there is a noticeable spike in “other current assets” in the latest period. “Other" assets include items such as prepaid expenses, legal fees, indemnity insurance, etc. While these types of assets are considered to have economic value, they have no direct role in producing income nor will they likely be converted into cash (such as inventory or receivables).

Next, we filter this data to identify operating cash-flow "OCF" and balance-sheet cash-flow "BSCF". In our model, operating cash should increase and balance-sheet cash should decline over time. The spreads between the two cash-flows produce our dual cash-flow ratio.

As you can see in the table below, OCF (circled) in the latest period is the highest in five quarters and much better than the average. In capital intensive businesses, BSCF is historically greater than OCF, but management at WMI has been consistent with their treatment of it. However, balance-sheet cash flow did increase 6% in latest period.

Finally, we compare trends in the dual cash-flow figures to changes in accruals. Our accrual screen is adapted from the research of Dr./Professor Richard Sloane. Accrual ratios < minus five (-5) signal a potential buy and anything > plus five (+5) should be avoided or considered a possible short.

How does WMI stack-up? In this very tough economy, WMI appears to be managing the store fairly well. Operating cash-flow has improved recently, but balance-sheet cash also rose slightly. Although trends in accrual ratios have deteriorated slightly, they remain less than zero which is preferable to a positive reading. A notable improvement in the cost of sales is offset by a decline in capacity utilization.

Conclusion: There’s lots to like about WMI, including a 4.5% dividend, which appears safe for now. But, with ten-year Treasuries yielding 3.45%, the 100 basis point spread between the two is almost too tight to consider buying the stock solely for the dividend.

However, for any investor seeking exposure to a basic (and necessary) industry with a renewable energy "kicker", Waste Management looks to be holding some aces in its hand. And, you get paid to wait!

Disclosure: Long WMI.

Comments

[La Marque:]

WMI is a buy because a) it is a recycler and creative (landfill to gas), b) environmental services are in great demand, c) that dividend should be safe, and d) as Jason Merriam says :Waste Management looks to be holding some aces in its hand. And, you get paid to wait! "

May 25 02:03 PM