Recently, JP Morgan released a downgrade of Waste Management (WM), citing challenging industry conditions from declines in recycled commodity prices, and its exposure to spot electricity prices. Perhaps a more pertinent note for dividend income investors is the concern that JP Morgan raised regarding a lower cash flow outlook for WM, which may hurt the company's ability to increase dividends (or buy back shares).
As a young investor (note the emphasis on investor), I have typically focused more of my attention on higher growth companies. However, I do believe in the safety provided by having a bit of a mixture of high quality dividend companies in any profile to decrease the volatility of one's overall portfolio, regardless of said investor's age. Additionally, with the markets near 5-year highs, and several overhanging macro-economic issues still clouding the air as well as my personal confidence, I have spent much of the last two to three months seeking low-volatility companies with a great yield to further balance my higher risk personal portfolio. This quest let me to Waste Management.
I was first exposed to Waste Management as it was featured in a favorable light on Jim Cramer's "Mad Money". I was impressed with the company's initiatives to lower fuel costs by converting much of its fleet to CNG engines, and management comments regarding the future of the business. However, I could not convince myself to buy at that time. Then the stock slid a couple of points, capped by the mentioned JP Morgan downgrade. The yield is now nearer to 4.5% than 4% (at prices at the time of this writing), which prompted me to dig into recent earnings and conference calls to determine if this is the opportunity to own I've looked for, or if JP Morgan analysts have hit the nail on the head advising investors to avoid Waste Management at this time. I first wish to know if the current dividend is safe and easily maintained. Then I will attempt to delve into concerns raised by the downgrade issued by JP Morgan in an attempt to determine whether WM will truly have difficulty increasing returns to shareholders in the form of increased dividends or share buybacks.
Let us first use the excavator's shovel and hit a few high points before taking out the archeologist's brush to uncover the crucial details.
· Current Stock price as of this writing is an even $32, with a dividend yield of 4.44% (nice yield, particularly when compared to Treasuries, for example).
· Annual dividend of $1.42, on trailing 12 month earnings of $1.97/share. This is a payout ratio of 72% of earnings -- somewhat higher than I would typically like to see unless earnings projections for future year is substantially growing, though not enough alone to question the safety of the dividend.
· WM has $237 million in cash, but $9.92 billion in long-term debt on the balance sheet. Not beautiful. However, the debt has been secured at an average cost of 5.1% so it should be manageable, provided it was issued to make moves accretive to the business.
In my mind, the current dividend is safe. Let us now delve into management commentary regarding the back half of the year and further to determine the future of the dividend if we can.
Management notes that the core solid waste business is performing well, with combined income from operations for collection, landfill, and transfer station business growing 3.4% year over year while margins expanded 60 basis points. They do, however, discuss multiple negatives, such as continued negative trends in residential business (though they state the rate of decline has steadily improved in six consecutive quarters).
Earnings per share for the second quarter of 2012 were $0.52, but it could have been better. The management team admits that earnings per share for the quarter were dragged down $0.07/share, primarily blaming declining recycled commodity prices, just as JP Morgan notes.
More specifically, these commodity prices were down 20% in 2012 Q2 compared to the same period in 2011. I am forced to agree, that is an ugly number.
However, as investors, we must look at where these prices are projected in the future in order to make our decisions. On this note, management projects continued declines in recycled commodity pricing through the second half of this year (though projecting these declines will be slightly offset as volumes continue to grow and customer demand persists for more recycling services). Overall, management projects EPS will be negatively impacted year over year by approximately $0.05/share for the back half of 2012. Again, not a rosy picture I'm afraid, and more evidence JP Morgan may have this one spot on.
Let us now consider the Waste to Energy portion of Waste Management's business to delve into their exposure to spot electricity pricing's impact on future earnings.
Management notes that the average electricity pricing declined by a little more than 10% in this quarter, creating a $0.03/share impact to Q2 earnings. They also expect negative impact from this facet of the business of $0.02/share year over year for the back half of 2012. Well crud -- JP Morgan's right again. Or, at least they are for now.
So what is management projecting in terms of earnings for full year 2012? Full year guidance has been lowered to EPS of $2.15-$2.20. Regarding Free Cash Flow for the full year, they are still maintaining expectations of $1.1-1.2 billion, assisted to some extent by divestiture of certain non-core assets to help offset higher capital expenditures and cash taxes this year.
They are careful to note that the core solid waste segment has grown and margins have continued to improve, which helped to grow EPS year over year over year despite headwinds as noted. This is a fact that is easily overlooked given the negatives described above, but one that should not be lost on the careful investor.
Of particular interest looking into the future, management discusses restructuring initiatives in the second half of the year that they specifically speculate will save the company over $130 million annually beginning in 2013. I have already mentioned the conversion of much of the fleet to CNG vehicles, a move that I believe will save the company money in the long run, and one that also shows management is actively engaged and dedicated to the long-term picture.
All I am capable of doing regarding potential increases in return to shareholders is speculating, but we can make a few very general assumptions going forward. Let us take the $2.20 end of full year EPS guidance. Apply the current 72% payout ratio -- assuming it remains the same going forward -- and you have a dividend of $1.58 (or 4.9% of current stock price), and a not-too-shabby yield. While I do not expect quite such an aggressive increase in the dividend, I do think it demonstrates the ability management has to conservatively increase it for years to come.
In the end, after this rambling series of commentary and conjectures made on my part, my investment thesis has shaped up thus: This seems to be a classic "pay you to wait" scenario. I am not qualified to conjecture about the prices of electricity or the hoped-for turn in recycling commodity prices. However, I can say this: The current yield is attractive, and there seems to be room for conservative increases until current headwinds are neutralized or even become tailwinds. Management has taken initiative to reduce costs in the out years, and I think this will ultimately become a huge benefit to shareholders. Let's face it. Trash and recycling services are going nowhere, and this company is a leader in the industry. I personally would be comfortable buying a portion of my position at current levels, and adding with substantial declines in stock price.
I am aware that this is not a comprehensive analysis. I have not discussed valuations, though with forward P/E of under 14 for a company with a 4+% yield, I do think Waste Management is attractively valued. There is a ton of room for discussion as to what this stock will do if the dividend tax cuts are allowed to expire. The list can go on. I still believe that 4.5% yielders that are the leaders in their industries are worth owning. It has certainly been true for companies such as Verizon (VZ) and AT&T (T), and WM may provide an opportunity to catch a big yielder that has lagged the indexes for some time. Call it a dogs of the non-Dow strategy.
It is my hope this article invites cordial debate to promote both cases for argument, and prompts further investigation into the company's fundamentals for fully informed investment decisions. As always, I welcome comments and encourage investors to do their own homework, though I hope this provides a visible starting line.