Finding Treasure in Trash
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Waste management is not a glamorous industry; it not only revolves around trash, it is also a maturing industry. However, there is often good value to be found in mature industries that have relatively low expectations for future growth.
With over $13.6 billion in revenues, Waste Management (NYSE: WM) is the clear market leader in the industry. However, the company has suffered from volume losses in eight out of the last ten years. Investors are afraid the drop-off in volume is an indication that Waste Management is not keeping pace with the evolving trends in the industry.
However, Waste Management is a free cash flow cow; it regularly produces over $1.1 billion in free cash flow, which is about 6% of its current market capitalization. Competitors like Republic Services (NYSE: RSG) and Waste Connections (NYSE: WCN) do not produce nearly as much cash as Waste Management. This gives Waste Management a tremendous advantage because it can regularly invest more in R&D to come up with innovative waste elimination solutions than its competitors.
This is similar to Intel's advantage over AMD; no matter what innovative technology AMD comes up with, Intel can always spend a ton of money to match it. Therefore, Intel will always be the dominant player in the industry. Likewise, Waste Management will always have the best technology, even if it has to play catch-up every now and then.
But that is not to say that Republic Services and Waste Connections do not have a fighting chance. Republic Services is investing heavily in recycling programs to add to its portfolio of services available to its customers. Meanwhile, Waste Connections is focusing on markets where it does not face heavy competition from Waste Management or Republic Services, which enables it to earn high margins despite a relatively low revenue base.
However, Republic Services will always trail its larger rival and Waste Connections does not pose a serious threat to Waste Management's market share. As a result, Waste Management should remain king of the waste management industry.
Over the last ten years, Waste Management has averaged an 8.53% free cash flow margin. If applied to the company's last four quarters revenues of $13.6 billion, the company will produce about $1.2 billion in free cash flow in a normal year.
That is a good estimate considering the company averaged $1.1 billion in free cash flow from 2003 to 2012. If you divide the company's current market capitalization -- $17.2 billion -- and by $1.2 billion in free cash flow, you get an initial yield of 6.77%.
But 6.77% is just an initial yield because that's what the company would earn if its asset-level and asset productivity remain the same in the future as they are today. Asset productivity has remained roughly the same over the last decade -- the company does not deviate far from its 11% pre-tax ROIC in any given year.
However, the company has grown sales at an annual rate of 1.85% over the last decade. Unfortunately, the growth did not come for free; Waste Management added 1.39% annually to its tangible asset base to achieve its annual sales growth. In other words, the company's sales growth is not adding value to the company -- growth in sales is coming as a result of growth in assets.
Since it appears that Waste Management is unable to even keep pace with inflation, an investment in the company's common stock is not a wise decision at just a 6.77% initial yield in an overheated market.
Ted Cooper III has no position in any stocks mentioned. The Motley Fool recommends Republic Services 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!