Toxic Waste Disposal and Recycling
NYSE symbol WM
The Short Version
At first blush, Waste Management seems to have a lot of attractive qualities for a long-term investor. The company is the dominant player in a field that has almost completely inelastic demand. However, after reviewing the annual report (available for download here) and digging through the company’s prospects, several concerns came up, such as the management’s lack of attention to detail in their communication, and the company’s exposure to highly volatile commodity prices. Looking to the accounting statements, it is possible for an optimistic value investor to justify a price of about $38.40 per share, but no more, making the current market price too high to qualify as an investment. Waste Management isn’t a screaming sell, but I’m not rushing to put my money in either.
The Long Version
I was rereading some of my favorite investment classics when I came up with my next investment analysis idea. In his book One Up On Wall Street, Peter Lynch advised that the best investments are always in boring companies and boring industries. The only thing better than a boring industry was a disgusting one – if the business made people wretch, it was worth looking into.
Lynch mentioned Waste Management specifically as a great example of his filosophy (… erm… philosophy). Because the company was involved in the disposal of toxic waste, he thought it was a great opportunity. Here was a company that did business that no one else wanted any part of, and provided a necessary service. I decided that if the company was good enough for Peter Lynch to look into, it was good enough for me, so I set down the book, downloaded WM’s annual report, and got to work doing what I always do – a quantitative and qualitative analysis of the company.
Right from the start, Waste Management has a lot of attractive features for a potential investor. While the company does not have the star-power or brand-fame that comes with Coca-Cola, Disney, or even Clorox, it is in a fantastic position. The company manages waste. While some companies are vulnerable to the changing times (technology companies in particular), there are some things that technology will never be able to change. We have people in this country, and people make waste. Someone has to deal with that waste. I don’t care how fast the next iPhone is, the only thing that will jeopardize WM’s core business is if people start to disappear (and if that happens, we have bigger problems than a declining stock market on our hands). It may be kind of gross to think about, but all the various forms of waste we generate every day must be handled – even as a bachelor I don’t just let trash pile up in my kitchen, bathroom, and bedroom – so Waste Management will always have work to do. As the earth’s population (and America’s population) grows, and as resources become more scarce, WM will have a constantly expanding market with more and more opportunities to create value for its customers in managing their waste.
Not only is the company in a business with inelastic demand, WM has become the largest player in the field. The company has been expanding for years into various new markets, and provides a whole suite of services on the management of waste. The company operates landfills, transfer stations, recycling plants, and several waste-to-energy plants that generate both electricity and natural gas from our waste. The company even mines landfills and waste dumps looking for reusable materials such as glass, metal, and plastic, and sells the material commodities. This is a double benefit in that it extends the life of a landfill with finite space, and also brings additional cash into the company. The fact that it helps save the planet by reducing our toxic waste is an additional bonus. Doing well by doing good – not too shabby!
In fact, the company has been embracing the green and sustainable push that has become ubiquitous. The company has been working to improve its single stream recycling and its waste-to-energy facilities. The CEO’s letter to shareholders is largely devoted to the company’s green initiatives and the push for WM to be more sustainable itself, and to offer sustainability to customers small and large. It is promising to see that WM views sustainability not as a luxury or a public relations gimmick, but as a fast approaching necessity. WM may not be in a flashy industry, but the management of waste is starting to undergo a very interesting change for the better, and it was good to see that the company is embracing this change.
Once I started going through the information in more detail however, the glow of Waste Management (a nasty image to begin with) started to fade. There are several concerning factors that popped up as I got deeper into my research. As I went on more questions were raised than were answered.
The first thing I read (as always) was the annual letter from David Steiner, CEO and President of WM, to shareholders. The letter goes through several of the usual motions, highlights the company’s progress towards various goals, lays out the plans for future expansion, and touches on plans to cut costs in the future. All fine and good, but something felt off when I read the letter. At first it was hard to put my finger on it, but on my second read-through, I managed to pinpoint some details that bothered me.
I noticed that while Mr. Steiner did make note of the company’s free cash flow (a critical metric for companies), he provided no detail about it, or how it compared to last year’s cash flow. This immediately raised a red flag – if the cash flow looked favorable compared to last year’s results, that would (or should) have been mentioned. Why wasn’t there a report comparing this year’s cash flow to previous cash flows?
More unusual – Mr. Steiner did not report diluted EPS in the shareholder letter. Instead, he provided an “adjusted diluted EPS” of $2.08 per share. Why was an “adjusted” version reported? What had happened to normal diluted EPS that made the management decide not to report on this number in detail? Unfortunately, my questions were unanswered. There were no other mentions in the annual letter about financial statistics, and no explanation of how good (or bad) the reported numbers are. Part of effective communication in a shareholder letter is explaining what metrics are used to measure corporate progress and why they are used.
This was not the only thing that I thought was missing from the letter. After reading it a few times, it finally struck me that though Mr. Steiner had mentioned shareholders several times, and had talked at length about the company’s green initiatives, there was nothing in the letter about the company’s employees. This was another red flag. There are nearly 44,000 employees at the company, and I presume that they are all doing something relatively important to the organization – if they aren’t doing important things, why the hell are they employed in the first place? It only seems natural that the people who make the company run every single day would be worthy of mention in the CEO’s annual communication to shareholders. Whether this was the result of oversight or arrogance or something else is irrelevant. It makes me question the management. I may be overly harsh here, but I prefer to lean towards overly critical than overly optimistic when analyzing a company – after all, you can’t lose money on a stock you don’t own.
At the end of the letter, I was left feeling that I hadn’t learned anything I couldn’t find from other sources. The whole letter was too sterile, and not detailed enough for me to really learn any information about the company’s plans and progress. To quote a friend of mine who had the same reaction as me, “it was clearly over-edited. It reads like a cheesy P. R. stunt.”
I walked away feeling Mr. Steiner’s letter was written either to distract or placate the investors of the company. Fortunately (for me at least), this did shed some light on the company and its management. First, the management doesn’t value the investors and employees as much as they should. Maybe it just didn’t occur to management to write about employees or to provide detailed analysis of their financial results. Maybe they actively avoided both subjects. Whatever the case is, I do not think it reflects well on Mr. Steiner and his team. Maybe these omissions don’t shed much light on the company’s operations, but they do reveal enough about the management for me to say that I don’t want them managing my capital. All in all, Waste Management gets a qualitative thumbs down.
Of course, if you know me (and given my small reader-base, I have to assume that you do know me), you know that any company’s stock might be a good buy if it is cheap enough. There’s only one way to figure out what “cheap enough” means exactly – an examination of the accounting notes. Let’s take a look.
A quantitative analysis of Waste Management takes a little bit of digging, but is comparatively easy next to large holding companies like Berkshire Hathaway, or diversified brands like Clorox. For all my qualitative qualms with the management of the company, they have done a fine job of sticking to their fundamental business and keeping their account records as simple as possible It’s still over 100 pages of stuff to read through, but I’ll keep it brief.
The first thing I always do is look to the balance sheet. Sometimes a bargain can be found if a company is selling for less than its tangible asset value – remember, the whole is worth at least the sum of the parts (and hopefully more). Waste Management’s balance sheet was kind of unique to analyze for a few reasons, but chief among those reasons was the nature of WM’s assets.
Because of WM’s line of business the assets of the company aren’t a completely fair picture of the company’s fire-sale price. WM owns lots of assets that usually would be considered safe long-term assets – most notably real estate. It is usually safe to say that while the real estate market rises and falls, if you own real estate you always at least have something tangible and usable. Unfortunately that is not the case with Waste Management’s landfills and transfer stations. As landfills are filled with waste, their real estate value is actively (and very quickly) destroyed. This isn’t necessarily a problem for the company if it brings in a healthy profit on that real estate, but it does make the book value of the shares a shaky way to value the company. The real estate might have cost a certain amount, but it has virtually no resale value.
Additionally, landfill real estate that the company owns now carries the double whammy of a set of future liabilities. A landfill only lasts an average of 43 years, and after it is filled, there are costs associated with capping the landfill and maintaining its closure safely. These are costs that WM has to bear for as long as they persist. Granted, the company does set aside assets to help pay for this maintenance, however it remains to be seen if this will be enough. The amount set aside is, by the company’s own admission, based on its own estimates of how much maintenance and closure will cost in the future, and how much interest can be gained on the capital set aside for the purpose. This exposes the company’s long term asset value to risk – if the company hasn’t set aside enough money, then earnings will suffer. With approximately 10% of all landfills expiring (filling up) within 5 years, this is a real concern.
With this in mind, a quick calculation of book value is very revealing. Taking the company’s stated assets ($23,097 million), and subtracting all liabilities ($16,422 million), the company winds up with a book value of $6.675 billion. Looking into the assets the company has, however, there is $6,291 million listed as assets under “goodwill.” Goodwill is a number listed on the balance sheet to represent the price paid for acquisitions in excess of book value. In a liquidation, goodwill is unlikely to pan out as a solid, reliable asset, so in calculating the firm book value, I always subtract it unless given a good reason to leave it in. Taking that number out, we are left with a “real” book value of only $384 million for the entire company. This number does also includes “intangible assets” worth $397 million on the company’s balance sheet. Intangible assets, while often real, rarely have any real value outside of the company – if we deduct these from the company’s “real” book value, the remaining figure is negative $13 million dollars for the entire company. It might be unfair to take out all of the goodwill on the company’s books when calculating value (or all of its intangibles), but even if I were to leave those line items in, the book value per share of the company is only $14.38 – just over a third of the company’s current market price ($41.39/share). That leaves a wide margin of danger, especially when we remember that many of the assets that WM owns are quite literally toxic. Benjamin Graham would not have been pleased. From a purist’s standpoint, WM does not qualify as a value investment.
However, a business is often worth more than the sum of its parts. If the business can create a steady stream of earnings consistently into the future, then the business has real value (even if it does not have any assets to speak of). Looking at Waste Management, the company seems to have some solid earning power. Going back 10 years, the company has always earned between $1.60 per share, and $2.23 per share, with the exception of 2003 (when it earned $1.21 per share). This is particularly promising given the massive financial crisis of 2008. While giants like AIG, GM, and GE were brought to their knees, Waste Management did not have a sizable shift in earnings (in either direction). That speaks to the safety of the line of business. If we take these figures at their face value, it turns out that WM had an average diluted EPS of $1.921 over the past ten years. Assuming that WM has the same basic earning power going forward that it had in the past (a big assumption which I will discuss in a moment), a value investor could pay up to 20 times the company’s average EPS and call it a fair price. This yields a maximum fair value of $38.42 per share in my eyes. An optimistic investor or speculator who believes in the company’s future growth prospects may even stretch to 25 times average EPS ($48.03 per share), but I can’t say that I’m too optimistic about WM’s current earning power, much less its future earning power, for a few reasons.
First, let’s remember that WM relies greatly on its landfills, 10% of which are within 5 years of closure unless they are expanded. Even if expansion occurs, it will require some extensive capital outlays to keep them in operation, and the ones that are closed aren’t simply left for dead. Closed landfills require capital to cap off and to maintain. These factors are sure to eat into Waste Management’s ability to earn in the future. How much they will impact the company exactly remains to be seen, but they certainly will impact the company.
Additionally, WM has a great deal of exposure to the volatile commodities markets. When WM recycles material, it sells the reclaimed products as raw materials. These include aluminum and paper – two commodities with prices and demands that have been falling lately. The price of natural gas and energy, two other commodities that WM sells, have also been falling, which is bad for revenues at the company. That is not to say that these prices will continue to fall forever, but the company’s exposure to these markets puts its future earnings on slightly shakier ground, since commodities prices are notoriously hard to predict.
Finally, the estimates above are based on the assumption that we can take WM’s diluted EPS at its face value over the last ten years. I’m not sure that this is a wise decision. Here is where the importance of a qualitative analysis comes into play. If I thought the management of WM was brilliant, and really excelled at capital stewardship, I would be willing to trust (but verify), the numbers in the books. As it is, I’m already skeptical about the company’s presented earnings. They might be legally accurate, but do they present the most accurate picture of earnings, or just the prettiest picture? Is the management’s judgement of how they tally earnings reliable? These are important questions. For example: this year’s diluted EPS was $1.76. The annual shareholder letter never once mentioned this number, instead reporting “adjusted” diluted EPS of $2.08. In the form 10-K, the adjustments that went into this difference are listed. Some make sense, and are only worth noting briefly (such as a few cents per share related to legal settlements). However, some piqued my curiosity but were not expanded upon. Most notably, there was a charge against earnings related to medical waste that had a negative impact of $.17 on EPS. Why was this charge against earnings singled out? What exactly did it entail? Why did management feel this medical waste issue was a one-time issue investors shouldn’t worry about? I’d love to give you more detail, but I have none to give. This general attitude towards earnings makes me too skeptical to automatically pay 20 times average reported earnings for the company.
It is also important to note that while revenues at the company have been reportedly growing, that growth is at least partially manufactured. Revenue grew over 2012, but only due to acquisitions. If you take out revenues created by acquisitions, it turns out that revenues decreased for the company by $43 million. That means the company’s existing core business has been declining. This is bound to happen in some years, but it certainly does not inspire a great deal of optimism in the company’s current direction – especially when that information is not addressed in detail by the management. A short explanation of why revenue from ongoing businesses declined would go a long way towards improving my opinion of the stock’s prospects.
An investor with more faith, or more knowledge of what is going on, might be happy to pay 20 times earnings, but no more. That would bring the maximum purchase price to $38.42 per share, lower than the company’s current market value of $41.39 per share. I am not sure what the price would make WM investment grade, but I am fairly confident that that price is l
All things considered, I’m not thrilled with WM as a stock. The company’s management has not demonstrated an appreciation for their role as capital stewards for the investors, and if they value the company’s employees, they certainly don’t show it. Also, the company’s earnings and cash flow are shrinking, and aside from acquisitions, the company doesn’t seem to have a roadmap on how to fix that problem. Yes, WM has a nice dividend, but that alone does not make the stock attractive. After all, a large dividend is only attractive if it is a safe dividend. On top of that, the stock simply looks over-priced relative to earnings, and why should I pay too much when there are fantastic bargains out there?
Maybe I am missing some details, maybe I am being to harsh on the company, but regardless, WM is not a buy as far as I’m concerned. It isn’t worth shorting – I don’t think the stock is going to $0 tomorrow – and it isn’t necessarily a stock I would rush to sell if I did own it, but I’m going to stay away and look for greener pastures.
– The Filosopher in Phinance
Disclosure – I have no financial interest in Waste Management, and no plans to change that fact.
PS – My attorney (Dad) has suggested that I remind my readers that while I do mention several statistics from the annual report, any analysis thereof is simply my opinion. This is a blog, so you shouldn’t assume that anything here is gospel.
Coming up on my next post – a new book review on Investing Between the Lines, by L. J. Rittenhouse. After that – a look at an American icon that has been through the ringer: Sears.