By The Valuentum Team
Waste Management (NYSE:WM) boasts the waste industry's largest and most diverse asset base, as well as a broad and diverse customer base. Long-standing customer relationships with a significant amount of contracted business help fuel its recession-resistant business model, which produces returns on invested capital at the upper end of its peer group. Solid cash flow from operations generation has allowed management to continually grow its dividend in recent years, and 2016 marked the 13th consecutive year of an increase in its quarterly payout.
The largest drawback to Waste Management's dividend growth potential at this point is its large debt load. As of the end of the second quarter of 2016, the company had total debt on its balance sheet of nearly $9.6 billion compared to just over $100 million in cash and cash equivalents on the books. However, the firm's net-debt-to-EBITDA ratio has improved in recent years, falling to 2.7x in 2015 from 3.1x in 2012, and it has best-in-class credit ratings.
While we think the company's essential-service providing business and solid free cash flow generation will be able to handle its debt load, it does have the potential to impact dividend growth as the firm may be forced to allocate incremental amounts of capital to servicing its debt. Other uses of cash can impact dividend growth as well, including share repurchases, which ate up $600 million in capital in both 2014 and 2015. Nevertheless, Waste Management's solid Dividend Cushion ratio of 1.6 gives us confidence that the firm will be able to continue delivering a growing and reliable dividend, just as it has for more than the past decade. However, based on our intrinsic value estimate--included in the 'Valuation Analysis' portion of this article--we see little valuation opportunity in shares at this point in time.
Waste Management's Investment Considerations
• Waste Management is the largest environmental solutions provider in North America, serving more than 20 million customers in the US, Canada and Puerto Rico. The company has the largest network of recycling facilities, transfer stations and landfills in the industry. It was founded in 1987 and is headquartered in Houston, Texas.
• Management expects 2016 to be a strong year, as it continues pricing and cost efforts established in 2015 to accelerate earnings and free cash flow growth. Investors should expect the firm to continue repurchasing shares.
• The firm's asset base is quite diverse. Its landfill operations boast significant barriers to entry due to regulatory requirements and stiff NIMBY opposition. The collection side of its residential business is generally recession-resistant, though volatile commodity prices can cause swings in recycling revenue.
• Its commercial and industrial pick-up operations are somewhat cyclical, however. More than 80% of its commercial and industrial customers have a contract length of 3 or more years, which provides some stability, but volumes in this economically-sensitive area can still be volatile.
• Waste Management has a hefty dividend payout, and the company's Valuentum Dividend Cushion ratio has improved. Dividend growth investors should expect annual expansion in the dividend going forward.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Waste Management's 3-year historical return on invested capital (without goodwill) is 18.2%, which is above the estimate of its cost of capital of 9.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Waste Management's free cash flow margin has averaged about 8.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Waste Management, cash flow from operations increased about 2% from levels registered two years ago, while capital expenditures fell about 3% over the same time period.
We think Waste Management is worth $56 per share with a fair value range of $45-$67.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3.2% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of -1.7%.
Our model reflects a 5-year projected average operating margin of 18.2%, which is above Waste Management's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Waste Management, we use a 9.5% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $56 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Waste Management. We think the firm is attractive below $45 per share (the green line), but quite expensive above $67 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Waste Management's fair value at this point in time to be about $56 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Waste Management's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $71 per share in Year 3 represents our existing fair value per share of $56 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.