Waste Management: Sitting On A Gold Mine (NYSE:WM) - Seeking Alpha

Waste Management: Sitting On A Gold Mine (NYSE:WM) | Seeking Alpha

Waste Management: Sitting On A Gold Mine
Waste Management, Inc. (WM) 4 Comments

Summary

- Waste Management has strong capabilities at scale and has been able to control expenses and costs effectively.
- The company is set to create significant growth in its renewable energy generation.
- Although it has higher debt load in recent years, we see them to be manageable.
- Its free cash flow impacted by higher CapEx is a reasonable and necessary investment at this time.

AzmanJaka

Investment Thesis

Company Overview

Waste Management (NYSE: WM), initially incorporated in 1987 with a principal office in Houston, Texas, is North America’s leading provider of comprehensive environmental solutions to manage and reduce waste at each stage from collection to disposal while recovering valuable resources and creating clean, renewable energy. Its two operating segments are East Tier ( the Eastern U.S., the Great Lakes region and substantially all of Canada) and West Tier (the upper Midwest region, and British Columbia, Canada).

Strength

Waste collection and recycling tend to be fragmented from having local counties and municipalities involved by default. The company builds a national network that creates more integrated value and competitiveness than otherwise. Throughout Waste Management's operations in the two geographical segments, vertical integration of collection, transfer, recycling, and disposal not only makes Waste Management more efficient but also more scalable. At a glance, its capabilities at scale are propagating technological know-how throughout the network including automation, self-service, and global business outreach.
Waste Management: Asset Scale and Capabilities (Company 2023 Q2 Presentation)

Waste Management has collection services for industrial/commercial and residential. The commercial contracts usually last for three years, while the residential contracts have exclusive rights granted by the local municipality. These services are either operatable by only one employee or have phrased in automatic systems instead of manual laboring. The fees in this segment of operations are generally very stable. For the company's landfill operation, due to the environmental requirements and limits on what waste is allowed in the landfill to mitigate air and water pollution, there is a significant capital requirement as a barrier to entry. Its 254 landfill sites represent the largest such network in North America. And for its transfer services, by utilizing its own transfer station, it is able to consolidate the waste into higher density for storage to reduce the trips and use locations strategically. Through the streamlining of collection, landfill, and transfer services, it can internalize a lot of costs and reduce fees charged by third parties.

Based on this strong operation, Waste Management is able to dig into the waste and transform it into "gold" through sustainability investment. There are not many companies as quintessential ESG as Waste Management, and this is a strong suit for the company to generate revenue.
Waste Management: Sustainability Investments (Company 2023 Q2 Presentation)

In recycling: Waste Management's differentiated recycling has multiple levers for value creation. Through its own Material Recycling Facilities, it processes and recycles materials, and commodities, and offers brokerage services to sell them in the N. American market. With the demand for recycled materials rising, the company has been able to use a fee-for-service model to receive inbound materials. When the commodity prices are low, it charges a fee to process, and when they are high, they provide rebates.

In renewable energy conversion: Methane that is naturally produced from its landfill gas is recognized in the same category as wind, solar, and geothermal resources by EPA (US Environmental Protection Agency). The company has 135 landfill sites for the beneficial use of landfill gas. 95 of them use the produced gas to fuel electricity generators, and in turn, the electricity is sold to public utilities, municipal utilities, or power cooperatives. While 23 of them use the gas at the landfill site or delivered as a direct substitute for fossil fuel to industrial processes. For the rest of 17 sites, the landfill gas is processed as pipeline-quality natural gas, sold to nat gas suppliers.
Waste Management: LandFill Gas (Company 2023 Q2 Presentation)

Since Waste Management produces renewable nat gas ("RNG"), it can generate Renewable Identification Numbers (RIN's) under the Renewable Fueld Standards ("RFS") program and a variety of state programs associated with it. The annual production currently the company has from five owned facilities produce 3.5 million MMBtu of RNG, producing revenue mostly through the sales via the RINs and related attributes. This RNG production is expected to grow by 8x to 28 million MMBtu by 2026, making it the fastest and largest growth spot in its renewable energy portfolio within the time frame. The EBITDA from the RNG is expected to add another $500 million by then, with $250 to 350 additional cumulative investment tax credits. Although the total landfill gas-to-electricity production looks to stay at a similar level, another growth for its portfolio is to add third-party processors. Its overall renewable energy portfolio is expected to grow to 135 million MMBtu by 2026.
Waste Management: Long Term Opportunities (Company 2023 Q2 Presentation)

The company quoted Bloomberg's research that RNG supply and demand unbalance will last into 2030, giving its growth a tailwind in the long term.
Waste Management: US RNG Supply and Demand (Company 2023 Q2 Presentation)

Waste Management produces renewable energy from non-renewable assets in the sense that most of these collection routes, landfill sites, and its vast network with exclusive rights and high entry barriers have certain uniqueness and non-regenerative properties. On top of this, it has continued to exercise better control of expenses and costs, supporting its reliance on logistics as an essential part of business operations. The operating expenses as a percentage of the retained earnings are only in the upper single digits. This rate has been on a secular declining trend for the past ten years because it has been able to keep the operating expenses at a similar level while delivering growth of more than 2x within that period.
Waste Management: Operating Expenses vs Retained Earnings (Calculated and charted by Waterside Insight with data from company)

In a clearly outlined performance metrics from its 2022 Annual Report, Waste Management stated that it expects Operating EBITDA to be above $5.132 billion to $5.532 billion, and an operating margin above 16%-19% to generate 60% to 200% of the payment to the executives, while topline growth of revenue is expected to be at or above 3-7% annually. It reached the upper range of all of these metrics and made 172.18% of the payment in rewarding the performance.
Waste Management: Executive Payment Thresholds (Company 2022 Annual Report)

Looking at its history, Waste Management has had very consistent margins in the past few years. Its gross margin has always been in the mid-30' percent, EBITDA margin at the upper 20 percent, operating margin in the upper teens, and net margin at around ten. It seems for last year, 17.5% was the satisfactory operating margin as a target. Such clear objectives also show that the management has sufficient visibility of its future growth, which translates into consistency in its business development.
Waste Management: Margin Analysis (Calculated and charted by Waterside Insight with data from company)

Weakness/Risks

Waste Management has accumulated a large amount of debt in the last three to four years. The rise in borrowing since 2020 was largely from long-term debt, which increased from around $3.5 billion to almost $6 billion, while its short-term debt has declined from $2 billion to around $1 billion. In the meantime, its level of debt has a strong correlation with its EBITDA. Although it doesn't directly imply causality, it is in general what investors want to see: the company has been using its capital effectively to generate more earnings while managing the debt payment.
Waste Management: Debt Effectiveness (Calculated and charted by Waterside Insight with data from company)

The company has been making higher payments to debt servicing. So far this year, it has made over $11 billion in the 1H. We don't expect a large or sudden hit of payments to its balance sheet, but this high level of payment annually would be here to stay for a while.
Waste Management: Payment of Debt (Charted by Waterside Insight with data from company)

We think its 2x debt-to-equity level is manageable given its stable margin in recent years. The capital boost has been helpful not only to its topline but also bottom line. However, the management would be wise to moderate or take a pause at the pace of borrowing and focus more on organic growth instead.

On the other hand, Waste Management's free cash flow reached a peak in early 2022 and has declined by almost 40% since early 2022. But it is not from a weakening operating cash flow, but more of a function of increased Capex.
Waste Management: TTM Operating Cash Flow vs Free Cash Flow (Calculated and charted by Waterside Insight with data from company)

The company has explained in its quarterly presentation that its capital expenditure was spent on sustainability growth initiatives. Without these investments, its FCF would have been flat to a slight growth. Although it expects such investment will continue to weigh on its FCF 2023, it is in the company's and the shareholders' best interest to upgrade its sustainable technological setup. In fact, for the company to continue capturing more ESG growth opportunities with more fiscal stimulus as the backdrop, now is the right time to invest. We don't consider it to be a drawback.
Waste Management: Free Cash Flow Breakdown (Company 2023 Q2 Presentation)

Financial Overview
Waste Management: Financial Overview (Calculated and charted by Waterside Insight with data from company)

Valuation

Given the analysis above, we use our proprietary models to assess its fair value with a ten-year projection forward. We use 5.72% as the cost of equity and 7.44% as WACC. In our base case, we factored in the 40% reduction of its free cash flow for this year and anticipate it to be still weak in '24, yet a strong rebound follows with an average mid-teen growth rate; it was priced at $140.88. In the bullish case, more steady growth was expected within the next five years in comparison to the base case; it was priced at $178.51. In the bearish case, somewhat higher volatility towards the downside was anticipated throughout the growth path in case there is some policy uncertainty; it was priced at $135.35. The current stock price is not overvalued, in our opinion.
Waste Management: Fair Valuation (Calculated and charted by Waterside Insight with data from company)

Conclusion

Against the greater demand for waste collection, recycling, and renewing with better technology and efficiency, Waste Management is not only well positioned to capture the wave but also poised to deliver much faster growth led by renewable energy generation. The waste it processes on a daily basis is like a gold mine that has more potential and continues to be discovered through technological innovation. Although the stock is at its historical highs, we deem it to be fairly valued with still upside potential to come.

This article was written by

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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