Waste Management: Advancing On Advanced Disposal Services Deal

About: Waste Management, Inc. (WM), Includes: ADSW
by: The Value Investor

Waste Management is buying ADS in a near-$5 billion deal.

Synergies make the deal worthwhile as investors like the move, given the great acquisition track-record of Waste Management.

I like the deal yet believe that shares are more than fully valued at current levels.

Waste Management (NYSE:WM) has reached a deal to acquire smaller peer Advanced Disposal Services (ADSW) in a $4.9 billion deal, creating a giant. The deal makes sense as synergies and a great track record mean that investors like the deal being made, although valuation multiples are too high for me to consider.

Deal Terms

Waste Management has reached a deal to buy Advanced Disposal for $33.15 per share in cash, valuing equity of that business at $3.0 billion, and the overall business at $4.9 billion if net debt is included. Based on the equity consideration alone, the premium amounts to 22%, although this premium drops considerably if we simply look at the equity valuation.

With the deal, Waste Management will not simply grow, it will notably grow in differentiated, sustainable waste management and recycling. With its 6,000 employees, which serve more than 3 million customers, Advanced Disposal adds $1.56 billion in revenues and $427 million in adjusted EBITDA. This suggests that the deal comes in at 3.1 times sales and 11.5 times adjusted EBITDA.

In term of operations, Advanced Disposal has 94 collection operations, 73 transfer stations, 41 landfills, and 22 owned or operated recycling facilities. Besides added scale and expertise in new regions, the deal is furthermore driven by a complementary asset network, which allows for a target synergy number of $100 million in combined annual cost and capital spending synergies. If synergies are included, the acquisition EBITDA multiple drops to 9.3 times.

For investors in Advanced Disposal, it has been a short "ride" as the company only went public in autumn of 2016, with shares being offered to the public at $18 apiece. Capital gains of 84% seen ever since, even if it took more than two and a half years, still translate into compelling returns for investors.

Pro Forma Implication

As discussed above, Advanced Disposal has generated $1.56 billion in sales in 2018. While the adjusted EBITDA number of $427 million looks impressive, that number is a bit misleading as well. The reported EBITDA number falls to $398 million if a range of adjustments are backed out, including landfill remediation costs, being very real costs, of course. The other big components of this metric are $96 million in interest expenses as well as $270 million in D&A charges. Note that capital spending only totalled $189 million last year, excluding acquisitions, as that provides net cash flows from "divestments".

In terms of EBIT numbers, I thus end up with merely $32 million in reported earnings before taxes based on the reported EBITDA number, although capital sending lags D&A by about $80 million. Adjusted for that, I peg EBT at $112 million, not that much, given the $3 billion equity component and EBIT coming in at around $208 million.

Waste Management itself is a much larger player with $14.9 billion in annual sales, as the deal will boost revenues by about 10%. It reported adjusted EBITDA of $4.2 billion as margins on the back of this earnings metric are quite similar. The 428 million shares represent a +$43 billion equity valuation ahead of the deal, with the enterprise value amounting to $53 billion if net debt is included. That is equivalent to 3.6 times sales and 12.6 times EBITDA, higher than the stand-alone multiples at which it is acquiring the business, not even accounting yet for the synergies to be realised.

Net debt will jump from $10 billion towards $15 billion upon consummation of the deal. With standalone EBITDA of $4.2 billion and adding the $427 million contribution from Advanced Disposal, I see leverage at 3.2 times or a little bit less if synergies are included. Contrary to Advanced Disposal is that, while EBITDA margins are similar, Waste Management is posting much better operating margins (GAAP basis) amidst lower depreciation expenses. Given the roughly $200 million incremental adjusted EBIT number by Advanced Disposal, financing costs will eat most of the anticipated earnings accretion, although deleveraging and sub 4% interest rates show that some modest accretion could be seen to the bottom line.

Market Reaction

The market is pretty upbeat on the deal despite the generous premium being offered. Shares of Advanced Disposal rose by nearly $5 per share to $32, leaving a small premium, given the risks related to deal closure, including that of approval, of course. With 90 million shares outstanding, that move represents $450 million in value as the premium itself comes closer to $550 million in value.

Shares of Waste Management did rise as well in connection to the deal, adding about $2.50 per share. With 428 million shares outstanding, that amounts to nearly $1.1 billion in dollar terms, for a combined value accretion to the tune of $1.5 billion, probably reflective of the great deal track record of Waste Management and the anticipation of $100 million in synergies.

While the market might be happy with the track record and promise of synergies, reality is that shares are not very cheap. Based on adjusted earnings of $4.20 per share, Waste Management trades at $104 at around 25 times earnings, with the earnings yield of 4% being not that much of a premium over risk-free rates, certainly given the leverage employed.

The market is applying a big premium, given the track record of the business and potential to do more value-creating deals in the future, as well as create new business lines from recycling and environmentally induced initiatives, while on the other hand, long-term volume growth might be pressured.

Final Thoughts

Reality is that Waste Management is an excellent long-term value creator which went public back in the 1970s and, at the time, has already made hundreds of acquisitions. Shares rose from single dollars to the $50s late 1990s as an accounting scandal and the 2001 downturn pushed shares back to $15 again.

Ever since shares traded in a $20-40 range until 2014 before gradually having risen to a little above $100 currently, as valuation multiples have expanded amidst the hunt for steady businesses in a low interest rate world. Note, however, that even though the business has been very successful in the long run, and the share price has risen a lot in recent years, shares have been trading stagnant for a long period of time as well.

While quality has a price, buying a waste business which relies more on pricing and M&A, rather than volume growth to drive growth, I am not too eager to pay 25 times earnings in combination with a 3 times leverage balance sheet, as expectations are simply quite high.

This should not be confused in any way or shape with leaning on the short side, as this industry lends itself perfectly for consolidation. It simply means that I do not see compelling risk-reward here currently, despite the great track record and what appears to be a reasonable deal again.

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.