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Summary

  • WM is a strong, stable player in a boring industry, perfect for dividend investors.
  • The company's yield is more than 1.5X greater than the market yield.
  • Shares are expensive but on a pullback, are a great addition to a retirement portfolio.

One of the most reliable sectors to invest in for dividend and income seekers is trash. No one wants to talk about what happens after we put our trash in the bin but for a couple of national players, it is a huge business. Waste Management (NYSE:WM) is the largest player in this space and has been a faithful dividend payer since the late 1990s. Shares have had an impressive run so in this article we'll take a look at WM to see if shareholders should think about lightening up on WM or if there is more room to run.

(click to enlarge)

To do this, I'll use a DCF-type model you can read more about here. Basically, the model takes inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at 6% growth annually, and a discount rate, which I've set at the 10 year Treasury plus a risk premium of 6%, reflecting the stable and predictable nature of WM's business.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.15

$2.36

$2.56

$2.75

$2.96

$3.18

x(1+Forecasted earnings growth)

9.80%

8.50%

7.50%

7.50%

7.50%

7.50%

=Forecasted earnings per share

$2.36

$2.56

$2.75

$2.96

$3.18

$3.42

Equity Book Value Forecasts

Equity book value at beginning of year

$12.56

$13.42

$14.39

$15.46

$16.63

$17.92

Earnings per share

$2.36

$2.56

$2.75

$2.96

$3.18

$3.42

-Dividends per share

$1.50

$1.59

$1.69

$1.79

$1.89

$2.01

=Equity book value at EOY

$12.56

$13.42

$14.39

$15.46

$16.63

$17.92

$19.34

Abnormal earnings

Equity book value at begin of year

$12.56

$13.42

$14.39

$15.46

$16.63

$17.92

x Equity cost of capital

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

=Normal earnings

$1.07

$1.14

$1.22

$1.31

$1.41

$1.52

Forecasted EPS

$2.36

$2.56

$2.75

$2.96

$3.18

$3.42

-Normal earnings

$1.07

$1.14

$1.22

$1.31

$1.41

$1.52

=Abnormal earnings

$1.29

$1.42

$1.53

$1.65

$1.77

$1.90

Valuation

Future abnormal earnings

$1.29

$1.42

$1.53

$1.65

$1.77

$1.90

x discount factor(0.085)

0.922

0.849

0.783

0.722

0.665

0.613

=Abnormal earnings disc to present

$1.19

$1.21

$1.20

$1.19

$1.18

$1.16

Abnormal earnings in year +6

$1.90

Assumed long-term growth rate

3.00%

Value of terminal year

$34.50

Estimated share price

Sum of discounted AE over horizon

$5.96

+PV of terminal year AE

$21.14

=PV of all AE

$27.10

+Current equity book value

$12.56

=Estimated current share price

$39.66

As you can see, the model has produced a fair value of about $40, standing in stark contrast to the company's current share price of $45.48 as I write this. We are talking about a deficit between my calculated fair value and the current share price of more than 11% and while that isn't huge, it isn't exactly trivial either.

We also need to note that the model does not produce a price target; it produces a fair value. The fair value computed is the present value of the company's future earnings stream, adjusted for dividends received, given the inputs I described above. In other words, WM would be a good buy from a value perspective at a price of $39.66 or under. Since we are trading over that, WM shares would appear expensive.

So what is driving the discrepancy? This is a story that we've seen play out with many dividend payers in our ZIRP environment where yield is hard to come by; shares of stable, predictable companies have been bid up in an attempt to capture the yield shares provide, thereby making the company more expensive than it otherwise would be. I think that is the reason we see WM shares trading for 18 times next year's earnings because its earnings growth rates certainly don't justify that kind of multiple.

If we look at the model we see WM is currently expected to grow in the range of 8% to 10% over the medium term and for a business such as WM, that growth is going to be hard to come by. The company has been posting ~3% gains in revenue in recent years so that alone will not get it nearly 10% earnings growth. There are efficiencies WM can gain to increase its margins but I think a big driver of earnings growth going forward is the buyback program.

The company has already been a buyer of its own shares but a recent announcement that it is selling its Wheelabrator unit has provided the company with some extra cash that it is planning to use at least some of to accelerate its buyback program. WM set a new buyback program at $600 million, or just under 3% of the float, over a six month period. It is this kind of activity that I believe is the only chance for WM to hit 8%+ earnings growth sustainably.

So what should we do with shares? If your timeframe is "forever" then you're probably content holding WM despite what I consider to be its overbought condition. The company pays a nice dividend and management has obviously made capital returns a priority, which I like very much. However, I also think shares are expensive and that I'd really like to see them under $40 before pulling the trigger. I am afraid there is a lot of downside risk to the company's current earnings growth forecast and that could lead to some multiple contraction in the future. Paying 18 times earnings for a company that is growing at ~3% annually is steep and I would prefer to get the shares a few dollars lower than they trade today. WM is a terrific company and long-term shareholders will do well but that doesn't mean you should pay too much.

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

Source: Waste Management's Dividend Is Worth A Look On A Pullback