Allied Waste: One Investor's Trash is Another's Treasure

We recently wrote about the S&P 500 (SPY) out producing all but 4 of the 60 industries for the week of March 10 to 14. So we decided to peek under the hood to look for index members that might prove to a good place for our readers to invest their money.

Our initial screen netted 11 companies that met the criteria we are looking for: performance that was on par or better than the index for the last month and week, and analysts increasing profit and sales forecasts for the remainder of 2008. Outperformance backed up by improving fundamentals is usually a recipe for a higher stock price.

After analyzing the 11 charts, 6 potential buy targets remained. We are going to focus on Allied Waste (AW).

Allied Waste is a garbage company that has been treated like trash by investors in the last year and probably deservedly so. Their business suffered from the double whammy of the slowdown in construction and higher fuel costs. As a result, AW’s stock has recently traded at its lowest levels since 2006.

But one investor’s trash is another investor’s treasure.

From a valuation standpoint, AW is a bargain relative to its peers. Allied shares are currently trading at around 1.2 times its book value of $8.97 per share. That’s a 65% discount to its closest competitors. AW trades at .64 times its sales, while the likes of Republic Services (RSG), Waste Connections (WCN), Waste Management (WMI) and Waste Industries USA (WWIN), Allied’s 4 main competitors) trade at 1.7x, 2.19x, 1.26x and 1.5 x respectively.

One of the reasons management and analysts feel it trades at this substantial discount is that AW has more debt, trading with a debt-to-equity ratio of 1.7 compared to the average of 1.15 for aforementioned peer group.

The only other outstanding issue is a dispute with the IRS that dates back to an acquisition. AW has taken action to mitigate the impact of a negative IRS ruling that in all likelihood won’t come until 2009.

Allied’s management is doing its part to improve its balance sheet. Since 2004, they have paid off nearly 1.6 Billion in debt. Worked diligently to cut costs, improve the efficiency and safety of their workforce, improved the condition of their fleet of trucks and pass along the cost of increased fuel charges.

These efforts have paid dividends as AW’s free cash flow grew from $250 million in ‘06 to $479 million in ’07. Management expects another $400 million in ’08.

AW could use this cash to increase shareholder’s value in a few ways: pay a dividend, repurchase shares, payoff more debt or acquire companies to fuel growth. Acquisitions appears to be the avenue management seems to prefer.

We expect that the continued improvement of the balance sheet throughout 2008 should narrow the valuation gap between AW and its industry. We are looking for returns of 30%, turning a 1000 share investment of $10,830 into a little more than $14,000.

On the downside, AW’s closing low of $9.30 on January 22nd should provide support. That’s a risk to reward ratio of 2:1.If by chance construction picks up and fuel costs go down in the months ahead, our $14 price target could be prove to be a little conservative.

A reading of AW’s chart shows a buy signal as the short term MACD average is crossing over the longer term average. This positive crossover has occurred 4 times in the last year for Allied. On each occasion the stock rallied.

Disclosure: none