Waste Not, Want Not
08/03/2009 11:28 am EST
Josh Peters, editor of Morningstar Dividend Investor, and analyst Bradley Meeks, say Waste Management has pricing power and profitability in a consolidating industry.
Despite a slowdown in waste volume from residential and industrial construction, we think Waste Management (NYSE: WMI), the nation’s largest trash disposal firm, will continue to provide increased profitability [through] higher prices and its asset-optimization program.
Owning landfills is the basis for the firm’s economic moat. Zoning permits can take anywhere from three to seven years to obtain and are costly. New landfill construction is typically greeted with community and political opposition.
Companies like Waste Management, which has the nation’s largest network of landfills, control pricing and can charge high landfill fees, or tipping fees, to other waste haulers that don’t have access to their own landfills.
As evidence, Waste Management internalizes 68% of its waste disposal at its own landfills and earns average operating margins of 15%; the industry average is 11%. Before 2005, waste haulers focused on market share through price competition.
However, as WMI’s profitability eroded, the firm decided to focus on increasing prices. Led by Waste Management, the industry has steadily increased prices over the past three years by increasing average core disposal prices by 3%. This has helped expand WMI’s operating margins from 13% to 17%.
In addition, the organization has implemented a fix-it-or-exit asset-optimization strategy, which will dispose of lower-margin businesses and unprofitable waste contracts. Although waste volume may be reduced because of this initiative, the firm can sell unprofitable assets and increase its returns on capital.
The greatest risk the company faces is the reemergence of irrational industry pricing, especially in light of volatility in fuel costs. We think this is highly unlikely, as recent industry consolidation, the Allied Waste-Republic Services (NYSE: RSG) merger, provides the perfect backdrop for sustained price increases now that two companies will control roughly 70% of domestic waste disposal.
More recently, waste volume has slid due to a slowdown in residential and industry construction. While lower waste volume could compress margins, we think further price increases will continue to offset volume declines, driving higher profitability for years to come.
With operating income covering interest expense 4.5x and a 57% payout ratio (on depressed 2009 profit prospects), we think the firm is striking a good balance between a determination to return cash to shareholders and [giving itself] adequate protection against cyclical fluctuations in profitability.
As Waste Management maintains disciplined pricing, we expect gains in operating margins and share repurchases to drive WMI’s per-share earnings and dividend growth potential more than revenue growth. Though near-term increases may be restrained by a weak economy, our long-run forecast supports a 7% average growth rate for the dividend.
With a 4.6% yield at our Dividend Buy price [of $25.40], we see potential for 11%–12% average annual returns. We admire Waste Management for raising its dividend in December when it would have been so easy to take a pass. (The stock closed above $28 Friday—Editor.)