Waste Management (WM): An Excellent Moat and 13 Years of Consecutive Dividend Increases

Waste Management (WM) is not widely known by dividend investors, but its moat and consistency are remarkable.

 

As the largest integrated waste management company in the country, WM possesses several key advantages that have enabled it to increase its dividend for 13 consecutive years.

 

While WM’s operating history isn’t as long as some other companies, its economies of scale, durability, unique assets, consistent free cash flow generation, and mission-critical services make the company one of our favorite blue chip dividend stocks.

 

Business Overview

WM is the biggest integrated waste management company in North America and serves more than 21 million residential, commercial, industrial, and municipal customers. The company makes money by entering into contracts with customers to collect, transport, process, store, and dispose of their waste. WM owns a variety of assets to run its business, including landfills, truck fleets, transfer stations, recycling facilities, processing plants, and more.

 

2014 Revenue Mix: collection 54%, landfill 18%, transfer 9%, recycling 9%, other 10%.

2014 Collection Revenue Mix: commercial 40%, residential 30%, industrial 26%, other 4%

 

Business Analysis

The trash business might appear to be a commodity industry at first glance, but it actually has substantial barriers to entry. As the largest player in the market, WM also carries several additional advantages.

 

First, it’s worth mentioning that there really aren’t any alternatives to trash disposal today. Consumers, municipalities, and businesses need to have their waste collected and taken off-site. With the average American generating several pounds of trash per day, there is a constant need for WM’s services.

 

All we see is a garbage truck that picks up our garbage can and drives on, but where does our trash really go? This is when WM’s valuable, hard-to-replicate network of assets comes into play.

 

Waste that is not recycled or processed into forms of energy is taken to transfer stations, which consolidate waste into larger, long distance trucks. These trucks take the waste to distant disposal facilities and landfills.

 

WM owns 252 landfills, more than its next two largest competitors combined. The number of landfills has fallen from over 7,600 in the mid-1980s to about 1,900 in 2013. That’s over a 75% decrease in less than 30 years! Government regulations, neighborhood restrictions, high start-up costs, and environmental concerns have all played a factor in the decline of available landfills.

 

While the remaining landfills are larger and more efficient than their predecessors, there are only so many places that waste management companies can park trash. WM’s competitors must pay WM a “tipping fee” to deposit waste at its landfills and use its transfer stations.

 

WM’s ownership of key assets, dense waste collection network, and tipping fees allow it to maintain a lower cost profile than its peers. This results in more waste volumes from customers (greater route density) and higher returns on its capital.

 

In addition to the toll-taking advantage WM has, new entrants also have a challenging time winning enough business to justify the significant investment needed to construct for their own disposal facilities. WM and other players already have contracts with customers, which typically last anywhere from two to six years.

 

WM has noted that more than 80% of its commercial and industrial customers have a contract length greater than three years, and the typical customer stays with WM for 10 years. New entrants have a difficult time securing the cash flow streams necessary to build their own trash disposal network.

 

Furthermore, WM’s large network of recycling facilities, transfer stations, and landfills make its business more flexible to meet the needs of virtually any customer segment – municipalities, construction sites, healthcare facilities, commercial buildings, and many others. Generally speaking, customers prefer to contract with proven operators that can meet a variety of needs.

 

Key Risks

WM’s revenue growth is somewhat impacted by the amount of goods consumed by consumers and businesses. When economic activity slows, less trash is produced and WM is not as busy. However, its trucks still run their routes and incur the same operating costs, somewhat crimping profitability.

 

Besides economic activity, solid waste volumes are gradually impacted by more efficient product packaging and the level of recycling activity, which diverts trash away from landfills.

 

Landfills have also received increasing scrutiny from governments regarding their impact on the environment, further accelerating the trend towards recycling and what are known as waste-to-energy (WTE) plants, which generate electricity from waste and sell it to customers such as utilities.

 

Importantly, WM is the largest residential recycler in North America and has the financial firepower to invest in whatever operations are needed to maintain its moat. The company is also a leading renewable energy provider.

 

If anything, we think the (slowly) increasing shift towards recycling and renewables will further strengthen the market positions of the biggest players because smaller competitors are unable to make the vertical integration investments needed to compete.

 

Whether or not these activities will be equally profitable is another question, but WM should find a way to stay relevant with its scale and collection of assets.

 

Additionally, lower commodity prices are hurting WM’s recycling operations (9% of sales). While not much can be done about this in the near term, WM is structuring new contracts and renewals to help it better deal with price volatility in the future and is improving operational efficiency.

 

WM’s management team is focused on improving the company’s return on invested capital, and we trust them to make the best decisions possible as it relates to recycling and WTE activities, which seem to have a more volatile return profile.

 

The company decided to divest a meaningful portion of its WTE business in late 2014 for $1.9 billion to maximize its focus on the core business, reduce earnings volatility, and improve its returns. We expect management to remain conservative with how they run the business and adapt to evolving waste management trends.

 

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. WM’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

WM has one of the safest dividend payments that income investors can find. The company recorded a dividend Safety Score of 97, suggesting that its dividend is safer than 97% of all other dividend stocks in the market.

 

Over the last four quarters, WM’s earnings and free cash flow payout ratios were 66% and 56%, respectively. For such a stable and predictable company like WM, these ratios are healthy and appear to pose little risk.

 

Looking further back, we can see that WM’s payout ratios have increased a bit over the last decade, but not by an extraordinary amount. In most years, the company’s payout ratios remained between 40% and 60%, leaving WM with plenty of dividend cushion and room for incremental growth.

 

 

Besides payout ratios, it is important to assess how well a stock performed during the financial crisis. A “safe” payout ratio can suddenly appear dangerous if earnings are very sensitive to the broader economy.

 

Fortunately for WM, consumers and businesses still have to consume a variety of goods regardless of how the economy is doing. Trash is a hard expense to avoid. WM’s sales fell by 12% in 2009, reflecting lower trash volumes but still outperforming many other types of companies.

 

Importantly, WM’s stock actually gained 5% in 2008, beating the S&P 500 by 42% and reflecting its defensive characteristics.

 

 

Analyzing a company’s return on invested capital can help us understand whether or not it has a moat. As seen below, WM has consistently recorded high-single digit returns. In many ways, WM’s business is somewhat like a utility company in that it practically has a monopoly in many local markets due to its landfills and extensive asset network. Since it is so capital intensive, the result is moderate but predictable returns on capital.

 

 

WM has also been an excellent free cash flow generator. Free cash flow is the lifeblood of companies and allows them to reinvest and return capital to shareholders without requiring debt or issuing shares. WM is a free cash flow machine because of its long-lasting assets (e.g. landfills, truck fleets), customer contracts, and route density.

 

 

A company’s balance sheet can also impact the safety of a dividend payment. Companies with too much debt could unexpectedly fall on hard times and need to suspend their dividend in order to service their debt.

 

WM maintains significantly more debt than the average company. Its assets are capital-intensive, but the company’s consistent free cash flow generation reduces its credit risk significantly. WM also has over $1.4 billion in unused and available credit capacity, and the company has noted that only 8% of its total debt portfolio has floating interest rates in case rates finally do start to rise.

 

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

WM’s dividend Growth Score is a little below average at 43. While the company has consistently increased its cash flow generation and dividend, it operates in mature, slow-growing markets. The company’s payout ratio is also north of 55%, which is still healthy but provides a bit less room for dividend growth than many other companies, especially considering the amount of debt on the balance sheet.

 

WM increased its dividend by 6.5% in December, making its thirteenth consecutive year of dividend increases. While it is only about halfway to joining the list of dividend aristocrats, WM has the predictable and durable business model needed to keep chugging along.

 

As seen below, WM’s dividend growth had been decelerating over the past decade until its announced increase earlier this month. We expect low- to mid-single digit dividend growth to continue, essentially matching the company’s earnings growth rate.

 

 

Valuation

WM trades at 19.6x estimated 2016 earnings and offers a dividend yield of 2.8%, which is significantly below its five year average dividend yield of 3.6%.

 

With an expected long-term earnings growth rate in the low- to mid-single digits, we believe the stock offers total return potential of 6% to 9% per year.

 

WM doesn’t appear to be a bargain for new money today, but we think the company’s impressive durability and moat make it worth holding onto – especially for investors living off dividends in retirement.

 

We expect to be rewarded with steadily improving earnings and growing dividend payments for years to come.

 

Conclusion

WM is a rock solid business. The company’s economies of scale, extensive network of well-placed assets, ownership of increasingly-rare landfills, annuity-like revenues (the average commercial and industrial customer stays with WM for 10+ years), and disciplined approach to capital allocation create a strong fundamental case to buy and hold WM forever. It’s no wonder why Bill Gates’ trust has made WM its third largest holding and also owns about 25% of WM’s next largest competitor, Republic Services (RSG).

 

We expect WM to continue improving its profitability over the coming years and rewarding shareholders with additional, albeit modest, dividend increases. For these reasons and more, we own WM in our Conservative Retirees dividend portfolio and don’t plan on selling anytime soon.