Waste Management: Make Garbage Green Again

Summary

• Waste Management is a relatively boring, recession-resistant business.
• Underlying capital allocation metrics are slightly above average.
• Valuations look steep.

Waste Management (NYSE:WM) looks like a boring business that simply collects your garbage, at least at first glance. It's also North America’s leading provider of comprehensive waste management environmental services. I've been attracted to the business for some time, ever since I found about its ability to turn landfill gas into clean, renewable energy. I'm not sure if this is going to be a huge growth driver for the overall business anytime soon - or ever - but it's definitely interesting enough to keep me watching the company. According to Waste Management's 10-K:

We develop, operate and promote projects for the beneficial use of landfill gas through our WM Renewable Energy organization. Landfill gas is produced naturally as waste decomposes in a landfill. The methane component of the landfill gas is a readily available, renewable energy source that can be gathered and used beneficially as an alternative to fossil fuel. The U.S. Environmental Protection Agency (“EPA”) endorses landfill gas as a renewable energy resource, in the same category as wind, solar and geothermal resources. As of December 31, 2017, we had 127 landfill gas beneficial use projects producing commercial quantities of methane gas at owned or operated landfills. For 102 of these projects, the processed gas is used to fuel electricity generators. The electricity is then sold to public utilities, municipal utilities or power cooperatives. For 13 of these projects, the gas is used at the landfill or delivered by pipeline to industrial customers as a direct substitute for fossil fuels in industrial processes. For 12 of these projects, the landfill gas is processed to pipeline-quality natural gas and then sold to natural gas suppliers.

Pretty interesting stuff, right?

The company currently owns or operates about 244 solid waste landfills, which is the second largest component of the firm's revenues, behind collections:

Source: WM 2017 10-K

The company's other businesses involve Recycling, Transfer, and Other (which includes its WM Renewable Energy organization). People will always need to have their garbage transported away and disposed of, in good economic times and bad, so this makes the company a natural fit for those looking for a less business-cycle sensitive stock.

Return on invested capital analysis

The first thing I'll point out about my model is the tax rate. I decided to use the adjusted, non-GAAP tax rate of roughly 36% (as opposed to the GAAP tax rate of only around 11%) to eliminate the one-time effects of a tax-related gain and other items. This information was provided by management in the firm's most recent 8-K.

Waste Management earns double-digit ROIC by my estimates, far exceeding its weighted-average cost of capital of only 4.49%. I also decided to run a range of different equity costs (due to the imprecise nature of estimating a true cost of equity), as well as the impact on overall WACC below:

I think that it's safe to say that Waste Management earns economic profits, where its ROIC exceeds its cost of capital (even assuming very extreme equity costs), and this is likely due to its size-and-scale, and even its geography (considering all of its landfills).

Return on equity analysis

Singling out the equity slice of the capital structure, we can now analyze returns to the equity holder, which benefit from leverage. Once again, I am using "non-GAAP" numbers provided by the firm's 8-K that excludes charges like the tax-related benefit in 2017.

The company has expanded margins at the operating level for three sequential years, but some of this is partly due to restructuring and other charges that the company included as operating expenses in previous years:

Source: WM 2017 10-K

Still, the firm boasts strong margins, and along with an improving asset turnover, it was able to increase ROE year-over-year, despite declining leverage. A lower tax burden going forward will also continue to provide a tailwind for higher ROE going forward as well, in my opinion.

Valuations

WM shares have tended to trade at about 18.92 times earnings historically, looking at the thirteen-year median multiple. Framing valuations within that context makes shares look pricey.

Analysts expect $4.02 in earnings-per-share for fiscal 2018, which puts shares at about 20.7 times those estimates - so shares still look expensive based on forward estimates. It's not until the end of fiscal 2019, when analysts expect roughly $4.40 in EPS, that WM shares fall back down to their historical median multiple based on the current share price.

Conclusion

I love Waste Management's collection of businesses and its relative resistance to recessionary times, but shares are simply too pricey here for my liking. The company has raised its dividend for over a decade now, and the last increase came in at over 9%. The current yield of only a little over 2% isn't good enough to entice me to pay up for shares at the moment, however, especially when considering the elevated starting valuations. I'll be watching from the sidelines for now until I can grab shares below 20 times earnings.

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