Why You Should Avoid The Waste Management Industry, For Now

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The waste management industry in the United States is a very concentrated one, with high barriers to entry and what Warren Buffett would call a wide economic moat. In short, it’s extremely hard for new entrants to swoop in and steal business from the established players.

The two biggest publicly-traded waste management companies that take the bulk of the market are Waste Management (NYSE: WM) and Republic Services (NYSE: RSG), and each have a devoted investor following because of their steady results and solid dividend yields.

At the same time, strong share price returns over the past year have belied relatively unimpressive underlying fundamentals. That’s why investors may be wise to avoid the industry for now, and instead wait for much better prices before jumping in.

Trash is no longer treasure

Both Waste Management and Republic Services are hailed as best-in-breed dividend stocks. It’s true that investors can receive strong payouts from both stocks, at roughly 3.5% and 3.1%, respectively. Those yields compare favorably to the 2% yield on the broader market, and investor starvation for yield likely explains why each stocks have rallied so strongly recently. Both stocks have climbed nearly 20% over the past year, despite a noticeable slowdown in growth.

Waste Management’s second quarter revenue inched up 1.9%. Net operating cash flow, meanwhile, declined 2% during the first six months of the year. The company is being adversely affected by a poor recycling environment, which matters quite a bit for Waste Management.

Average recycling prices were 12.5% lower in the second quarter, serving as an anchor on earnings. The recycling environment isn’t expected to improve, either, and Waste Management expects to be negatively affected by recycling operations for the remainder of the year.

Republic Services, meanwhile, is performing much better than its major rival. The company reported 2.5% revenue growth in its second quarter, and 10% growth in operating cash flow over the first half of the year.

And, Republic Services isn’t being nearly as adversely impacted from recycling. Republic Services saw only a 0.3% drop in recycling commodities pricing in its second quarter.

An interesting choice for die-hard income investors is Veolia Environnement (NYSE: VE), which can satisfy your desire for a high-yield as well as for international diversification. Veolia is a $7.5 billion environmental management provider based in France and offers a 5.5% payout according to Yahoo! Finance.

Veolia has a pronounced footprint in the U.S. as well, but again, we see iffy underlying fundamentals and a stock price sitting atop its 52-week high. Veolia’s first-half revenue declined 3.3%, due to worsening conditions in its Water and Environmental Services segments. Management attributed this weakness to the soft construction industry.

And, it’s worth noting that Veolia isn’t in the best financial shape. At the end of the first half of the year the company had $4.78 billion in cash, down from $6.59 billion this time last year. Veolia also holds more than $13 billion in net debt.

Positively, though, management isn’t standing still on this issue. Veolia plans to sell assets to buffer its balance sheet, to the tune of more than $7 billion, with the hopes of bringing net debt down to roughly $10.5 billion.

Organic growth is hard to come by

As previously mentioned, the waste management industry is a mature one, meaning underlying growth is a difficult proposition. In turn, Waste Management has resorted to a bolt-on acquisition strategy to engineer growth.

Waste Management recently acquired two energy service companies in an effort to expand its oil and gas industry penetration. This may pay off in the long-term, but for now, Waste Management’s slowdown in profit growth and dividend growth is concerning.

After granting investors an 8% dividend raise in 2011, Waste Management’s last two dividend increases have been 4.4% and 2.8%, respectively. Quite simply, this level of paltry dividend growth isn’t enough for a 3.5% yielder trading for 22 times earnings.

Republic Services, meanwhile, has kept up its strong dividend growth, recently announcing a 10.6% increase in its payout. This is indicative of the company’s stronger free cash flow generation over the first half of the year.

Pass on trash, for now

Waste Management is the major player in the industry, but I continue to believe it’s not worth $40 per share. The extremely mature nature of the industry means slow growth for the time being.

I consider Republic Services to be a better company than Waste Management, but even so, both stocks are trading too richly for my taste at 22 times trailing EPS.

Veolia is an interesting choice for investors starved for yield in our current low-rate environment, but again, we see questionable fundaments in conjunction with a rising share price.

I can’t advise investors to pay 22 times trailing earnings for companies in a very mature industry such as waste management. As a result, I’d recommend that investors wait for 10% to 15% pullbacks before allocating capital to these well-run businesses.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Republic Services, Veolia Environnement (ADR), and Waste Management. The Motley Fool owns shares of Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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