Waste Management: Dividend Safety is Declining

Waste Management Inc. (WM) is the largest collector and disposer of trash in North America.

-Seven Year Annual Revenue Growth Rate: <1 br="br">-Seven Year Annual EPS Growth Rate: N/A
-Seven Year Annual Dividend Growth Rate: 8.8%
-Current Dividend Yield: 4.31%
-Balance Sheet Strength: Leveraged but Stable

I view Waste Management as a fair investment at the current price in the low $30's, but there are concerns. Lack of volume growth is hurting EPS, and the dividend has continued to grow by gradually increasing the payout ratio. This cannot be sustained forever, and WM must reverse income loss and achieve at least mild growth in order to continue to increase the dividend at a reasonable rate. Over the short term, the dividend is safe, but over the long term, improvements need to occur to maintain dividend growth.

Overview

Waste Management (WM) is the largest processor of waste in North America. With over 44,000 employees, WM collects tens of millions of tons of waste in a year, and recycled 12.9 million tons of material in 2011. They also generate energy via landfill gas and through burning waste.

Waste Management has a rather unappealing business to most: they deal with trash. But from an economic perspective, their business model is enviable.
-Customers pay Waste Management to remove their waste.
-Waste Management recycles the material that is recyclable and gains some cash flow.
-Waste Management can use a combustion process to turn waste into energy- enough to power about 700,000 homes which provides another stream of cash flow.
-Waste Management deposits a lot of trash into landfills, and generates additional cash flow by charging fees for lesser waste companies to also deposit trash into their landfills.
-Waste Management uses the methane that comes up from landfills to produce electricity for which they can generate more cash flow. They generate enough energy this way to power about 500,000 homes.

Revenue breakdown

Waste Management’s $13.378 billion in revenue for 2011 came from the following ways:
Collection accounted for $8.406 billion in revenue.
Landfill accounted for $2.611 billion in revenue.
Transfer accounted for $1.280 billion in revenue.
Wheelabrator (waste-to-energy) accounted for $877 million in revenue.
Recycling accounted for $1.580 billion in revenue.
“Other” accounted for $655 million in revenue.
Intercompany accounted for ($2.031 billion) in revenue.

Eastern, Midwestern, Southern and Western regions for the company produce almost the same amount of revenue each, so the company is balanced rather evenly nationally.

Collection

For commercial customers, WM typically makes a three year agreement and charges fees based on a variety of factors. They supply metal containers with their logo, and trash can usually be picked up by a truck with only one employee. For residential customers, WM typically makes a 1-5 year agreement with an organization like a municipality or homeowner’s association for exclusive collection rights in that area. They also charge some residents directly depending on location.

They have also launched a new product called Bagster, which is a strongly woven bag that can be purchased at certain stores. It can hold three cubic meters of material, and is more economical for medium sized trash projects than renting a metal dumpster. After purchasing and filling the bag, a customer calls WM to have the bag picked up for a fee. It’s useful for small home renovation, clearing out junk, and certain business applications.

Landfill

WM operates 271 landfills. They deposit most of their collected trash into their own landfills, which keeps the profit margins high. WM charges fees for other trash collectors to deposit into their landfills. After a landfill is full they cover it with earth so it can be used for other purposes. WM also operates 5 hazardous waste landfills.

Transfer

WM uses 287 transfer stations to compact trash and then send it to a landfill. In more urban areas, landfills may be far away from the pickup site, so WM and other garbage collection companies deposit trash into the transfer station. WM charges fees for their services to other collectors.

Wheelabrator

WM owns or operates 17 waste-to-energy facilities and independent power production plants. WM burns solid waste to boil water to produce steam that produces electricity, which they can sell into wholesale electricity markets.

Recycling

WM recycles plastics and commodities from their collection activities.

Other

-WM manages the marketing of recycled materials for third parties.
-WM provides sustainability services to businesses.
-WM collects methane from their landfills and sells it to produce electricity.
-WM offers solutions for healthcare waste.
-WM invests in companies that are supplementary to their own industry.
-WM rents out portable restrooms and provides some street-sweeping work.

Ratios

Price to Earnings: 16.3
Price to Free Cash Flow: 16.2
Price to Book: 2.5
Return on Equity: 15%

Revenue

(Chart Source: DividendMonk.com)

Waste Management’s revenue growth has averaged less than 1% per year over this period. As can be seen by the chart, revenue has practically been flat save for a small decrease during the financial crisis.

Trash collection is an industry that is recession-resistant but obviously not recession-immune. People still generate trash and recyclables in any market, but a weak economy means less production and less construction, and therefore less waste generation.

Earnings and Dividends

(Chart Source: DividendMonk.com)

Earnings growth was nonexistent over this period. Net income for the company has been mildly downward, while share repurchases have partially offset this by reducing the share count, which has resulted in fairly flat earnings per share.

As for dividend safety, the chart is worth a thousand words. While EPS has remained static, the company has continued to grow the dividend. The average dividend growth rate over this seven year period was 8.8% per year. This shows the importance of maintaining a reasonable payout ratio, since they were able to continue growing the dividend through a period of growth difficulty. But it also sounds some alarms on the sustainability of future dividend growth, since a manageable payout ratio only keeps the dividend safe for a while. With a current dividend yield of 4.31% and a dividend payout ratio of around 70%, the dividend is safe at the moment. But if income doesn’t stabilize, and if share repurchases are not enough to grow EPS, then the dividend growth will have to slow to nearly a halt. At this point, a dividend cut looks rather unlikely any time soon, but dividend growth is at risk.

Balance Sheet

Waste Management’s balance sheet is a weak point, but when the company’s consistent revenues from a necessary, asset-heavy industry are thought of basically as a utility, its balance sheet remains reasonable.

Total debt/equity is 160%, and all of equity consists of goodwill. Total debt/income is a bit over 10, meaning that if all income were to be focused on debt reduction, it would take roughly ten years to pay the debt off. The interest coverage ratio is a bit over 4, meaning operating income covers interest expense at least four times over.

Overall, I view the balance sheet as a bit stretched, but not risky in the short term. It’s worth keeping an eye on if one is an investor in the stock or interested in investing in the stock. I’d be a bit wary if debt/equity or debt/income increased much more than this, or if the interest coverage ratio were to dip under 4x or 3.5x or so.

Investment Thesis

The average person disposes of 4.5 pounds of waste every day. Trash is a fairly defensive business, because regardless of how the economy is, people are still throwing things away, and trash removal is absolute necessary. Still, a sluggish economy reduces the volume of trash, and modestly decreases profitability. Since WM has a lot of fixed, asset-heavy costs, a greater volume in trash results in better profits for WM. This is why the net profit margin hit a peak of over 9% and then decreased to below 7%

Waste Management uses its cash flow pretty well, in my view. In 2011, the company spent $696 million on dividends to upkeep the current 4.31% yield, spent $575 million on share repurchases, and spent $831 million on acquisitions. An acquisition of this size is not the norm for this company; it’s the largest annual expenditure in the last 10 years or more. So in most years, most of the free cash flows go to shareholders as dividends and to a lesser extent, buybacks. In July 2011, WM acquired Oakleaf Global Holdings, which added $580 million in revenue, thousands of trash haulers, and hundreds of customers, to their operations.

I find it doubtful that net income will continue to decrease even with continued investment. Population continues to grow in the United States. Operating landfills provides a certain type of moat, because they’re rather undesirable in a neighborhood and therefore difficult to initiate. In addition, the company is growing their other income streams. The company recycled 12.9 million tons of material in 2011 and targets 20 million by 2020. They produced enough energy from landfill gas and from burning trash to power 1 million homes in 2011 and they target 2 million by 2020.

For this investment to be a decent one, the threshold for growth is fairly low. Merely holding net income static, or growing at 1-2% per year, would result in a decent investment when all the free cash flow is continually given back to shareholders.

Risks

Waste Management’s core industry of trash is always going to be necessary, but WM does face risks. They are susceptible to energy prices for powering their vast army of vehicles and operations, though they have been offsetting some of this by using their own liquified gas for vehicles. While they are in a conservative industry, they are still susceptible to economic weakness because trash output decreases during times of economic recession. Waste Management also faces risks in the form of contract losses to competitors if they don’t manage their business well. Focuses on environmental sustainability, and business initiatives to produce less trash, can potentially reduce volume for WM. If net income doesn’t stabilize and resume mild growth, dividend growth is at risk.

Conclusion and Valuation

Waste Management currently pays dividends amounting to a 4.31% dividend yield, and in 2011 repurchased approximately 3.7% of the market cap in shares, which they tend to do every year in varying amounts. Sustained perpetually, assuming an unchanging stock valuation and zero net income growth, as well as reinvestment of dividends, that would result in 8% total returns from dividends and capital appreciation.

As it currently stands, however, net income has decreased over the last several years. Share repurchases have therefore only roughly held EPS static rather than increasing it. In addition, the current amount of dividend payments and share repurchases combined are not supported entirely by free cash flows, but instead by a combination of free cash flows and issuing of more debt than is repaid. The free cash flow yield is only around 6%, so without growth, at this valuation, returns should be limited to the mid-single-digits.

Investing is about the future rather than the past. The current valuation isn’t supported for a decent rate of return if the same performance over the last several years continues for another several years. Either investors are settling for a very low rate of return compared to what they could expect from several other dividend paying companies, or more likely, investors in aggregate expect net income to stabilize and for dividends and mild EPS growth from buybacks to provide a return in the higher single digits. Stabilization and mild growth of net income, combined with dividends and share repurchases, could result in mid-to-high single digit returns, so the bar for success is set pretty low. At the current time, while I view WM as a fair investment, I’m looking elsewhere into MLPs, telecoms, and consumer products companies, for investments.

Full Disclosure: As of this writing, I have no position in WM.
You can see my dividend portfolio here.

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