Waste Management (WM) - Valuation Analysis

Description

Waste Management, Inc. is a holding company and all operations are conducted by its subsidiaries. The Company is a provider of waste management services in North America. Its subsidiaries provide collection, transfer, recycling and disposal services. The Company is also a developer, operator and owner of waste-to-energy and landfill gas-to-energy facilities in the United States. The Company manages and evaluates its operations through five groups. The Company’s four geographic operating groups, consisting of its Eastern, Midwest, Southern and Western Groups, provide collection, transfer, disposal and recycling services. Its fifth Group is the Wheelabrator Group, which provides waste-to-energy services, and manages waste-to-energy facilities and independent power production plants (IPPs). In January 2010, the Company acquired City Wide Recycling LLC.

Source: Reuters

Valuation

Key assumptions included:

                Terminal growth rate: 3.0%

                Risk-adjusted discount rate: 9.6%

                Cost of sales: 72.0%

                Selling, general, & administrative costs as % of sales: 11.7%

                CAPEX as % of sales: 10.0%

                Depreciation as % of sales: 9.0%

                Effective tax rate: 28.0%

                Day sales in receivables: 48

                Day sales of inventory: 5

                Days payable outstanding: 28

At a 10% growth rate (bull case), I estimate the intrinsic value of WM to be $36.94 per share.  With a risk-adjusted margin of safety of 9.9%, the target purchase price is $33.27 per share.  This is above the $30.73 per share WM is currently trading at.  At $30.73, WM is trading at 16.8% below the intrinsic value indicating it is a value in this scenario.

At a 5% growth rate (bear case), I estimate the intrinsic value of WM to be $29.97 per share.  With a risk-adjusted margin of safety of 13.7%, the target purchase price is $25.87 per share.  This is below the $30.73 per share WM is currently trading at.  At $30.73, WM is trading at 2.5% above the intrinsic value indicating it may be overvalued in this scenario. 

Dividends

Waste Management has paid a quarterly dividend since 2005.  From 2005 to 2010, WM’s dividend has grown from $0.80 per share to $1.26.  The dividend appears to be grow in line with forecasted earnings.  The compound annual dividend growth rate is as follows:

                Five years: 12.0%

                Three years: 9.5%

Although the dividend appears to be growing in line with earnings, the dividend appears to be sustainable.  Based on net income, the dividend payout ratio has exceeded 50%.  A dividend payout ratio of less than 50% is a positive allowing for sustainable growth and a cushion for short-term earnings volatility.  From 2006 to 2010, the dividend payout ratio based on net income has grown from 41.4% to 63.4%.  Below is the dividend payout ratio for the past five years:

                2006: 41.4%

                2007: 42.6%

                2008: 48.9%

                2009: 57.2%

                2010: 63.4%

In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return.  The model is called the Dividend Drill Return Model (DDRM).  It is based on the premise that the dividend total return is equal to the yield plus dividend growth.  Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase). 

Given a core growth rate of 10.0% and current dividend yield of 4.4%, WM’s cost of growth is $1.37 per share.  After reducing this amount and dividends of $1.36 per share, the funding gap is $0.75; this amount is forecasted to have a -2.4% impact on share price.  As a result, the DDRM forecasts the projected total return for WM to be 12.0%.  Below is a breakdown of the total return:

                Core growth rate: 10.0%

                Dividend yield: 4.4%

                Funding surplus: -2.4%

                Total return: 12.0%

Summary

In a bull case, based on a valuation $36.94, shares are trading at a 16.8% discount to their intrinsic value.  In a bear case, base on a valuation of $29.97, shares are trading a 2.5% premium to their intrinsic value.  WM has a short history of dividend increases and the dividend appears semi-sustainable as the payout ratio is more than 50%.  Based on the DDRM, the projected total return for WM is 12.0%.

Disclosure: I am long WM.