Waste Management (WM): A Capital-Intensive, Wide-Moat Garbage Collector That A Middle-Aged Warren Buffett Would Like
by JONATHAN DANIELSON
Waste Management is not a cheap stock. It does, however, have nearly all the markers of a really good business. And it doesn’t necessarily look overvalued at these levels either. It leads its industry, has consolidated returns that look to be both of high quality and extremely stable in nature, looks to have a wide moat which will be discussed further below, and all easily discernible indications would lead to the conclusion that management is competent and perhaps even value-add. Waste Management might not be a quantitatively cheap stock, but then again it’s the type of stock that never really looks too cheap. As far as valuation multiples go we have to go back to the Financial Crisis to see a time when the P/E touched low double digits. So, it’s the type of stock that takes a true crisis for it get into the “standard” fair value range as far as valuation multiples are concerned. We could classify it as a blue chip stock. Even though most normal day-to-day people are probably not familiar with the company, most investors are certainly aware of it. It would probably get the attention of a 1980s Warren Buffett. In fact, if you’re reading this write-up then you might be aware that site-favorite Allan Mecham (everyone’s favorite hedge fund manager) owned WM back in the early 2000s.
So we know Waste Management is a leader of its market, they also have a long runway for growth, and in addition the market in which they operate is extremely durable and continually generates robust cash flow throughout various economic cycles. The reasoning for this is pretty intuitive. That is, people are going to have trash whether or not the economy grows or contracts by X% in a given fiscal year. Now the degree to which the company is sheltered from the economy is minimal, I want to stress that. But the business isn’t overly cyclical certainly. Compared to most companies – certainly compared to the index – WM is a far more stable business.
Given that the characteristics of this company are such that investors only need complete preliminary due diligence to begin to reach the conclusion that WM is likely to be extremely high quality, the goal of this article is to serve as a comprehensive overview of the business.
Business Overview
Founded in 1971, Waste Management (WM) is a Houston, Texas based company with 43,700 employees and services over 20 million customers. Of the greater than 20 million customers, close to 18 million are residential, 1 million are commercial, and .2 million industrial. No one single customer accounts for more than 1% of total revenue.
Waste Management is its current form is largely the product of the late 1990s merger between Waste Management and USA Waste. Management has described the several years following this merger as the darkest in the company’s history. The entire industry had been on a buying spree as the industry leaders were swallowing up all of the small to midsize players. Waste Management had ultimately taken on too much debt and acquired unrelated/non-core assets. The acquisition proved much more difficult then management anticipated. The stock cratered by >65% and new management was brought in. Since the 1990s the company, although still consolidating the industry to some degree, has changed directions materially by placing more emphasis on achieving adequate returns on capital employed and returning capital to shareholders. Waste Management, as it stands today, is the market leader with only two other notable competitors operating at the same level as WM.
As the name would suggest, Waste Management is a waste service provider to their commercial, industrial, and residential customers. Put simply, Waste Management is a company that collects and disposes of garbage. They also operate 314 Transfer stations and offer recycling to their customers. Waste Management owns and operates the largest landfill network in North America, which was 247 sites as of their latest filing. This is their principal asset and serves as the main source of their moat, which will be discussed further below. On an operational level, the main place of contact for the business with their customers is the collection phase. This segment totaled 54% of revenue in fiscal 2018. For the commercial and industrial side of the company, they typically have contracts with these customers that are 3 years in length. Waste Management provides the trash containers (typically the large steel bins you see in the back of a business) and then charges a fee for the service which varies on a customer-to-customer basis. On the residential side of the collect business, Waste Management usually has contracts that are not shorter than 3 and not greater 10 years with the local governmental body or homeowners’ association. Typically these contracts are for Waste Management to exclusively service all or some portion of homes in a given area – the barriers to entry here are especially compelling and don’t need to be expounded on. Break down of each customer type is as follows: Commercial 41%, Industrial 29%, Residential 26%, and Other 4%.
The next operational phase of the business is taking the collected items to the Transfer stations. Approximately 10% of revenue comes from this segment. The company owns 314 of such stations (technically a portion of these are leased, but WM operates and collects fees at all of these sites). At these stations the waste is compacted to a smaller size and shipped off to the disposal sites.
Further, Waste Management operates 247 Landfills (20% of revenue). This is simply a designated area where the company can dispose of the collected waste. The regulatory and capital requirements in order to set up and maintain these sites are substantial. The average landfill typically costs $550,000 on a per acre basis. WM has over 150,000 acres in total with the average site totaling over 600 acres. This substantial amount of capital required is why WM provides local regional players the option of using Waste Management’s site and paying a “tipping fee”. This aspect of Waste Management’s business model is one of the key differentiators between them and the regional players. The assets the company has simply cannot be duplicated by competitors. Waste Management has the largest asset base of its kind in North America.
Separately, recycling is also available to the company’s customers. Once said waste is recycled, it is sold on the market at the spot price. This aspect of operations does open the company up to sensitivity from the recycled commodity prices. To illustrate the inherent unstable nature of this line of revenue, in 2017 revenue for this segment was up 20% while the following year, 2018, it declined by 20%. Nevertheless, the impact on the business of this exposure to commodity prices is negligible as only ~9% of revenue is sourced from this line of business.
Durability
The waste management services industry is not one investors are likely to get euphoric about. There are no society-changing innovations currently underway, no business magazines writing about which CEO is the Next Steve Jobs, and no “reasonable” forecasts of neck-breaking growth rates. You won’t find the next undiscovered Amazon with this industry is basically what I’m trying to tell you. So if there’s no potential for awe-inspiring growth rates then what does this industry offer investors?
Stability. This industry is unusually immune from a changing competitive landscape. While no competitor operating in this industry is going to invent the next product the world has to have, investors also get the peace of mind that no competitor is going to fundamentally change the game. A durable product is one that is worthwhile of investor’s attention. And with the waste management industry, that’s precisely what investors get.
As we live in an era that could arguably be considered the most economically competitive as has been seen, as the trend towards globalization continues relentlessly forward, the internet continues to usher in competitive forces and bring down what were once considered god-like businesses – Waste Management offers investors a safe haven, as it remains sheltered from most forces of competition. It does so as there is no conceivable way the services the company provides could be outsourced to nations with lower cost structures. Technological advances that threaten other industries largely appear to benefit and even enhance the business models of companies in this industry.
Let’s take the clean energy movement as an example. Hybrids/electric vehicles appear to be the method of choice to combat the negative effects cars have on the environment for most governmental bodies and corporations moving forward. Along with this movement we have autonomous driving that is currently on the receiving end of billions of dollars in capital investment from some of the largest players in the world. Both of these industry trends serve as existential threats to numerous business models. But Waste Management already has trucks that are fueled by natural gas and has stated that they are willing and able to make further investments in their fleet by way of electric and autonomous trucks – the technology just simply isn’t feasible yet. It doesn’t appear to me that using clean cars would necessarily have an impact either way as it pertains to WM shareholders, but it should be relatively easy to envision a scenario where autonomous vehicles would prove to be a positive for the company. While Management hasn’t disclosed any exact figures (as it would be far too soon to do so), any reduction in the cost of labor the company has to incur with the operations of the fleet would obviously benefit shareholders. So with this case at least Waste Management, and along with its industry at large, appears to be on the beneficiary end of technological advancements. Even if it turns out labor costs are not reduced (if the fleet still has to manned in order collect the waste) then worst case this major societal change would prove to be a non-event for the business.
While there are certainly innovations that might affect the company that we haven’t discussed, the point remains that this a mature, extremely durable, and inherently stable industry that doesn’t appear to be going anywhere anytime soon. As long as there is trash in the world, someone has to collect it. And as long as someone has to collect it, there will have to be somewhere they take it to.
Quality
This is the type of industry that tends toward an oligopoly. It wasn’t always this way, however. Up until the 1990s the waste services industry was largely fragmented. The reasoning for this is that it just was not all that difficult to start a waste collection services company. There wasn’t anything in particular differentiating the business models. This led to a proliferation of regional participants that could compete strongly at the local market level. The force that mostly started to change this was regulation. At the crux of it, this is a government-made oligopoly. This certainly isn’t the only industry where governmental agencies have regulated the competition out of business, so the topic should be familiar to readers.
As noted above, this is what fueled the consolidation of the industry leading up to the turn of the century. Smaller competitors simply couldn’t compete anymore due to the costly regulations. If you don’t want to take my word for it, here is Mr. Boettcher, Chief Legal Officer of Waste Management at the 2019 investor day,
“I think in general the starting point for us with regulation is we thrive in a heavily regulated environment. The mom and pops and the smaller players tend to fall out because they are not as good at complying with regulations. So we don’t, we don’t sort of shy away from regulation, we are not living in fear of the regulatory environment, and of course, the picture you paint where it could get too far the other way, that could be damaging to any industry if it goes all the way to heavily regulated environment or too regulated environment. But I don’t think we see that.”
The three market leaders as it stands today are (from smallest to largest): Waste Connections, Republic Services, and Waste Management. Corporate-level economics are largely what you would expect from a company that is largely capital-intensive yet enjoys several competitive advantages. Using the 2018 annual report, the company’s net tangible assets look as follows:
Working Capital: $(463)
Net PPE: $11,942 billion
NFA: $11,479
Waste Management did $2.7 billion in operating income in 2018. That’s works out to a little over 23% for returns on capital employed. That means at an operational level, returns are more than adequate, especially considering the nature of this business (lots of required capital). But the company has acquired a meaningful amount of companies, so goodwill is a substantial figure on the balance sheet. At the end of 2018, it came to roughly $6.4 billion in goodwill. Once we factor goodwill into the equation, returns drop to 15% (using EBIT still). What this tells us is that the underlying operations of Waste Management and the companies they acquire are very compelling (20%+). But in order to grow by acquiring other companies, WM has to pay a premium to book for the companies, thus lowering corporate-level returns. So while the true economics of the business are exceptional, returns for shareholders are meaningfully reduced due to the prices the company pays in order to make acquisitions.
A 15% return on total capital is still good, however. I don’t want readers to be mistaken. It’s just that incremental returns aren’t as good as the underlying returns of the business. Any growth that can be achieved at a 15% return should definitely be taken advantage of.
The next post mark of quality is one that we have already hit on earlier – WM’s stability. As an indicator of stability one obvious method is to check how the company in question fared during periods of economic contraction. Waste Management performed relatively well during the last recession, as both gross and operating margins held steady throughout the downturn. Top-line revenue did contract by ~15% but it should be pointed out that the nature of the most recession was particularly hostile towards Waste Management’s business model. Given that residential customers are by far the largest type of customers that the company has, they were particularly affected by the downturn in the housing market. It’s unlikely future recessions will be as extreme as the most recent one and they are unlikely to be the same in type. Viewed under these lens, it makes the performance of the business during the most recent recession that much more impressive.
We’ve already discussed one source of the company’s moat: it is large enough so that it can afford to handle governmental regulations and since smaller companies can’t afford these same regulations, they have to either be bought out or go out of business. While that one is obviously important, I don’t view it as the most important source of Waste Management’s competitive advantage. What separates Waste Management even from the other players is this chart:
The asset base that can’t be replicated and is the main source of WM’s moat
Competitors simply can’t copy the assets WM has. While the collection service business may continue to have medium sized players, there can only be a set number Landfill and Transfer sites that are economically viable. This gives the company both pricing power and staying power. It gives the company staying power because trash that has been generated in the United States has to be dealt with in the United States. There really isn’t a second opinion here. Second, this is a largely capital-intensive business, further making it infeasible for smaller competitors to try and recreate what Waste Management has already built.
As far as the economics of the sites go, there is quite a bit of operating leverage inherent in the business given its capital intensive nature. Incremental margins are high, making this business a textbook example of the advantages of scale. Management disclosed that excluding non-cash charges, incremental margins on Landfills equate to roughly 70%.
Growth
There really are only three ways the company can grow moving forward. I’ve hit on one of them throughout this write-up – WM can further consolidate the industry. This seems to be a strategy that has a long runway. Despite there being over 20 years of industry consolidation, there are numerous regional companies WM can further acquire. An example of such a company was illustrated by management earlier this year when they acquired Advanced Disposal Services (ADS), a company that added over 3 million customers in the Midwest and southern regions.
The additional two ways the company could grow are through either price increases or volume increases. Management has long maintained the stated strategy of increasing volume over increasing prices. Given the tailwinds the company has as it relates to volume growth (growing population, an increasing amount of trash, etc.), the strategy appears reasonable.
Investors shouldn’t anticipate double digit growth by any means. This is largely a mature industry and any further growth greater than GDP is likely to stem from acquiring smaller competitors.
Management
As I touched upon briefly in the introduction, the Company’s management appears to be extremely experienced and have, at the very least, not detracted any value from the company. All or most have been with the company or in the industry for most of their working careers and a handful of them have even worked in the field in their early days.
Insofar as compensation goes, the average executive receives greater than 60% of total comp via the long term equity compensation program. And although insider ownership is minimal, incentives don’t appear perverse. So this isn’t a founder-led company whose entire net worth is aligned with yours, but it’s not nearly as bad as a management who is indifferent to shareholders. Judging by management’s actions and their words, they appear to be very shareholder friendly.
The only Management change that is really noteworthy (as there have been some others) is the new CEO as of 2016: James Fish. Fish took the CFO position in 2012. He hasn’t spent his professional career in the waste management industry but he does have 7 years’ experience working in the field.
The takeaway from the evaluation of management is largely that I don’t find anything troubling – no red flags. Management seems adequate.
Valuation
For a broad overview of where the company currently stands today as it relates to valuation levels, some statistics: Market cap: $50 billion, Enterprise Value: $64 billion, P/FCF: 25, EV/EBITDA 14. The two most notable peers listed above trade roughly in the same ballpark. No one of them trades too far away from the pack.
At current levels, I think the only investors who should be seriously considering a position in WM are those who are truly long term holders. If you’re more active than Warren Buffett is today (you aren’t going to hold until judgement day), then WM probably wouldn’t be too enticing at these levels. At current prices, I tend to view WM as an extremely, extremely attractive long term bond. This is probably the type of company that would interest dividend investors. I tend to frame the situation more as a bond because of the company’s cash generating ability. Over 50% of EBITDA is converted to free cash flow. A little less than 40% of free cash flow is paid out in dividends. The company is extremely stable and likely to grow moderately moving forward.
So what could an investor today expect to earn moving forward?
What an investor would get today is a company that’s trading at ~4% free cash flow yield that’ll pay you a little more than 1% in dividends every year and has the potential to grow modestly moving forward. I don’t believe the company is mispriced at current levels. What you’ll earn is completely dependent on how the business performs. There’s not likely to be an expansion in the stock’s multiple in the future from today.
If we want to look at the stock as an entire enterprise then we can consider what fair value for the company would be on an EV/EBIT basis. For a company that has the business dynamics I laid out above in addition to the possibility of achieving GDP%+ growth for the foreseeable future, that company should reasonably be worth 20x. On a per share basis, that brings us to ~$127/share, or roughly a 10% upside from here.
Even though I don’t view the business as terribly mispriced today, that doesn’t mean I think shareholders are likely to be worse off owning the stock. A 4% free cash flow yield for a business as good and as stable as Waste Management’s certainly is attractive. If we assume the Company will be able to achieve 3-4% top-line growth over the next year, and that the market will eventually value the company closer to a 2% free cash flow yield, then there’s certainly a path to 10% returns over 5-10 years. That’s probably much better than the market will do.
The problem in my eyes is that there’s no margin of safety at these levels. If the business doesn’t grow, if an acquisition is botched, or margins begin to contract then I don’t see how an investor buying today would be protected. However, if you are truly a long term shareholder or if the dividend attracts you, WM could make sense in a portfolio that’s diversified with blue chip-type stocks.
Potential Pitfalls
That said, what are the potential risks in investing in the name today? Well, the major one is acquisitions. The company is extremely acquisitive, even as it has slowed down dramatically since the 1990s. Since 2016, WM has acquired slightly less than 90 companies which represents about 12% of the Company’s capital allocation. Being a minority outside shareholder we simply don’t have the information needed to judge each and every acquisition on its own merits. For the larger ones we tend to know the price paid and what multiple this represents, but we can’t really track each acquisition’s IRR on an individual level. We know that acquisitions have added value in the past as returns have remained adequate and top line growth has been achieved. But we simply have to maintain confidence management will continue to act in a disciplined manner moving forward. This risk is somewhat mitigated by the fact that management has spent close to 50% of free cash flow on returning capital to shareholders.
Another potential risk involves what I would call political rhetoric. Political activists have been known to be vehemently opposed to the Landfill method of waste management. Obviously they prefer recycling. Economically speaking, the Landfill method is far and away the superior method of choice. While it is incredibly unlikely for the company to have its business of choice regulated away, it should be noted that those who are politically concerned tend to prefer recycling. Granted, this is largely an extremely long term risk that has a minimal chance of coming to pass.
The risks section of this write-up seems as good a time as any in which to discuss the company’s leverage profile. Over the past 5 years the Company has brought down net down to EBITDA from a little under 3 to a little over 2. The company recently made an acquisition, which was discussed above, and took on debt to finance it. There haven’t been any quarterly or yearly financials filed so we don’t know exactly what the financial profile will look like. But close to 3x EBITDA seems a reasonable speculation. With a company with characteristics as Waste Management, debt tends not to be too much of an issue assuming management isn’t completely inept. So is the case with WM. Although if I were a shareholder I would certainly be watching management’s willingness to take on leverage particularly in order to finance acquisitions.
Conclusion
Waste Management is the market leader of an industry whose characteristics consist of producing robust cash flow and achieving GDP%+ long term growth. Waste Management offers investors a unique segment of the market to invest in that is stable, durable, and to some extent recession-resistant. Additionally, I believe the stock offers investors with the opportunity for relative outperformance on a risk-adjusted basis. The company is extremely good, very safe, and cheap enough to outperform the broader indexes over the long term.