Description

I am recommending the purchase of Waste Management common stock (WMI) based on what I believe to be a compelling risk/reward proposition.  I believe WMI has very little downside risk (~10%) at current levels with 50% upside over the next few years.

WMI is by far the largest player with better than a 25% share in the roughly $45 billion solid waste management business, which comprises collection companies, transfer stations, landfills and recyclers.  I previously recommended another company in the space--Waste Industries in December of 2003 at $9.26, which now trades (too rich in my judgment) at $25.75.  The garbage industry, though by no means sexy, is a very attractive space.  It is a necessary service business with no offshoring risk, no technology risk, no Wal-Mart risk etc.  Moreover, I believe the industry structure is changing, led by WMI, which provides significant upside, which I will detail after providing some background.

I will not spend much time describing WMI, which has a decent website (www.wm.com), public disclosure and analyst coverage.  I will provide some background though because I believe it is important to understand the industry structure.  The garbage business was for a very long time a very fragmented, local business.  WMI was the first of many consolidators in the industry, and consolidation was boosted by the imposition of regulations governing the construction and operation of landfills.  These regulations had the effect of substantially increasing the cost (and time) to construct, operate and then ultimately close and care (post-closure obligations) for a landfill.  The local dump became a thing of the past, and the large, costly modern landfill replaced it, with the result being dramatically fewer but much larger landfills.  Today, WMI is by far the largest landfill operator in the U.S. with nationwide operations and some of the most attractive locations available.  This is a critical strategic asset, impossible to replicate on a large scale and the key to the value chain in the industry (more on this later).

The consolidation in the industry reached a fevered pitch in the go-go 1990s as virtually all the midcap garbage companies were swallowed up by the major consolidators, each of which executed literally hundreds of acquisitions.  When the dust settled, there were three large industry leaders:  WMI (the product of the merger of fellow consolidator USA Waste and Waste Management), Allied Waste (which acquired Browning Ferris) and Republic Waste (Wayne Huizenga’s second industry rollup after the original Waste Management).  The Waste Management/USA Waste merger was a disaster, a rollup that had hit the wall as the Company had scores of systems and cultures that had not been adequately integrated and a management team not up to the task of running such a large business that had come together so quickly.  For the first time, WMI reached outside the waste management industry for a CEO, recruiting an executive from the trucking sector.

WMI spent the next several years getting its house in order, consolidating all the acquired companies, streamlining systems and focusing on productivity.  The Company also fundamentally changed its strategy.  Through 1999, WMI viewed itself as a growth company/consolidator.  New management saw WMI for what it had become:  a leader in a steady, albeit mature industry with limited growth prospects due to its sheer size and market position.  The strategic focus shifted to enhancing productivity, wringing out efficiencies, and getting price increases with a view toward higher ROIC and ultimately returning cash to shareholders in the form of a dividend and buybacks.  As a result, WMI has increased operating margins by 200 bps since 2004 (to 15.5%) and is poised to continue expanding margins (I believe 18% is achievable in 2-3 years).  The pricing piece is relatively more recent and has been aided by both the increase in fuel costs in recent years, providing cover for price increases, and a similar strategic shift at Allied Waste and Republic over the same time frame.  Allied has likewise reached outside the industry for leadership and, in part due to necessity, is pursuing much the same strategy as WMI.  For perhaps the first time ever in this industry, the tree top players, who command a large share of the market (and most importantly, the landfill capacity in most major markets), are focused not on market share or top-line growth but on ROIC, pricing and cash flow.   I believe the market is underestimating this shift in industry structure and the beneficial impact it can produce for WMI for years to come.

Landfills are the key to the value chain in the industry because disposal is far and away the largest cost component.  The hauling/collection business has relatively few barriers to entry and, at the local level, marginal pricing can be driven by the mom & pop operator with a few trucks, who typically looks at the business as providing an income and doesn’t earn appropriate returns.  However, this operator’s largest cost item, by a factor of 3-5x is the cost of disposal.  Vertically integrated players like WMI have an advantage in this regard and, ultimately, increased disposal costs at the landfill must be passed on by even aggressively priced hauling companies because they cannot afford to absorb such costs.  WMI has the best portfolio of landfills (nearly 300 in total) in the industry.

WMI has been very clear about its strategy to get price increases, even at the cost of volume.  When the Company announced earnings recently, the stock sold off on concerns over the cost to volumes in Q4 and prospectively in 2007 as a result of the pricing initiatives.  I believe this represents an opportune time to get into the stock as I believe the Company has the right strategy, is making demonstrable progress toward it and has an opportunity to significantly improve returns as it gets more pricing success.  I also believe that management’s guidance for 2007 will prove conservative if the economy remains healthy.  In the meantime, you own an industry leader with a shareholder friendly management team trading at 18x earnings, just over 8x EBITDA, a free cash flow yield of 5.6% (>7% including planned divestitures in 2007) and with a dividend yield of 2.7% and an active buyback program (between dividends and buybacks, WMI has returned approximately $2.7 billion to shareholders in the past two years).  With the dividend yield, buyback program and all the private equity money sloshing around, it is hard to imagine much downside from current levels.  Indeed, the so-called infrastructure funds have recently purchased inferior assets in the industry at 10-12x EBITDA.  If WMI can continue to generate traction with its pricing and efficiency initiatives, I believe it can increase free cash flow by 25-50% over the next three years, which with attendant multiple expansion could generate >50% upside with very little risk along the way.

Catalyst