By The Valuentum Team
One of the core strengths of Waste Connections' (NYSE:WCN) trash-taking and disposal business is the low level of local competition its vertically integrated operations face and the solid pricing dynamics it experiences as a result. The company knows how to build route density and drive efficiencies like the very best of waste haulers out there. Gobbling up assets is part of that strategy.
Even before its deal with Progressive Waste, Waste Connections' municipal solid waste business was quite resilient and recession resistant, and we like what increased local scale and a widening geographic footprint can do for such a business, provided management is able to extract expected benefits and synergies from the transaction. The deal is expected to provide over 20% accretion to adjusted free cash flow per share in the first year of the combined company's operations, and we'll be monitoring progress.
Now don't overreact as we tend to be debt-averse analysts, but we're not particularly fond of Waste Connections' large debt load. As of the end of the first quarter of 2016, the company had a total debt position of nearly $2.1 billion, compared to cash and cash equivalents of just over $9 million. The company isn't in any financial trouble by any stretch, but all things equal, companies with outsize net cash positions are in much better financial shape. In Waste Connections' case, we think the firm's free cash flow generation should be able to handle its debt service, but we'd like to see the firm deleverage rapidly before the next downturn.
With income investors having a choice of Waste Management (NYSE:WM) and Republic Services (NYSE:RSG), Waste Connections' dividend yield leaves a great deal to be desired. Still, management has shown reasonable willingness to increase the payout in recent years. Though debt service will put some pressure on future dividend growth, we think the company has material room for expansion, and its reliable solid waste operations will be the backbone for ongoing increases in the payout. The new firm plans to maintain pre-merger Waste Connections dividend initially, and it will review the payout each October. Let's do some more digging into the investment considerations of this trash taker.
Waste Connections' Investment Considerations
• Waste Connections is the third-largest publicly traded solid waste company in the US and focuses on secondary and exclusive markets. We like its strategy as it facilitates vertically-integrated operations that have less competition and better pricing dynamics. The company was founded in 1997 and is now headquartered in Canada.
• The company's solid waste business is quite resilient, but investors cannot ignore the risks associated with reduced exploration and production activity in the energy sector. E&P waste represents about ~$275 million of revenue.
• The waste industry has become more rational in recent years. Price-led growth within the space should drive continued margin expansion and increased free cash flow at Waste Connections. The firm recently completed its purchase of Progressive Waste Solutions for $2.67 billion and has expanded into Canada as a result.
• Since 2011, Waste Connections has consistently experienced free cash flow growth in the mid-teens while making appropriate investments. Management expects its 50% free cash flow conversion rate to continue in 2016, to ~$375 million for the year, compared to ~$343 million in 2015.
• Though Waste Connections is growing faster than Waste Management and Republic Services, its valuation is still pricey. We're not rushing to jump into shares at present levels.
Note: The year-over-year 'Diluted EPS, YoY%' growth rate for 2016 is negative because it accounts for inflection of negative earnings per share in 2015 to positive earnings per share in 2016. Due to a large non-cash impairment charge in 2015, net loss attributable to Waste Connections was ~$96 million.
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 Connections' 3-year historical return on invested capital (without goodwill) is 16.2%, which is above the estimate of its cost of capital of 9.8%. 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 Connections' free cash flow margin has averaged about 14.9% 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 Connections, cash flow from operations increased about 19% from levels registered two years ago, while capital expenditures expanded about 14% over the same time period.
We think Waste Connections is worth $48 per share with a fair value range of $38-$58.
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 18.9% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of 8.4%.
Our model reflects a 5-year projected average operating margin of 14.1%, which is below Waste Connections' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Waste Connections, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Note: The 5-year growth rates for 'Earnings before Interest, CAGR %' and 'Earnings per Share, CAGR %' are negative because it accounts for the inflection of negative earnings per share in 2015 to positive forecasted earnings in the future years (2015 is the base year). Due to a large non-cash impairment charge in 2015, net loss attributable to Waste Connections was ~$96 million.
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 $48 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 Connections. We think the firm is attractive below $38 per share (the green line), but quite expensive above $58 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 Connections' fair value at this point in time to be about $48 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 Connections' 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 $64 per share in Year 3 represents our existing fair value per share of $48 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.