"One person's trash is another person's treasure." There are perhaps no truer words to describe the refuse collection and recycling industry, or its largest player, Waste Management (WM 0.27%).
The trash industry is hardly a glorious business by any means. But, it's also a business that provides a basic-needs service that homeowners can't go without: trash collection. Because of its basic-needs status, refuse companies across the board have delivered slow but steady gains to investors over the past decade.
For Waste Management in particular, it's been a mixed year with its shares up 7%, though it's still underperforming the S&P 500 as whole; and it hasn't been an easy ride.
Headwinds facing Waste Management
While the bulk of Waste Management's revenue is derived from its refuse collection business ($2.16 billion of its $3.56 billion in the second quarter), weakness in the company's recycling business has been dragging on its results for multiple quarters now.
Just like metal miners which sell their product at spot prices, Waste Management is subject to the volatility of metal spot prices in its recycling business. Since the beginning of 2013 a majority of recyclable metals have seen their spot prices drop by double-digit percentages as China's demand for precious metals has declined, and euphoria surrounding the metals trade as a whole has waned.
The end result for Waste Management is that it has needed to be aggressive with cost-controls in this segment of its operations. Despite reporting a positive $0.01 per share impact from last year for its recycling operations in Q2 2014 as a result of restrictions placed on what it will recycle and how it provides rebates on recyclables to its customers, it still recorded a year-over-year decline in its recycling commodities' average yield.
Source: Redwin Law via Flickr.
The other big worry that Waste Management faces is the ongoing loss of market share via mergers and acquisitions. Roughly a decade ago Waste Management's big advantage over its peers was its sheer size. Covering more of the nation geographically and having deeper pockets gave Waste Management more pricing leverage with its customers. In other words, the refuse business doesn't offer a lot of options for consumers. In some instances consumers don't have a choice with regard to which refuse company they use, and that's great news for Waste Management.
However, Waste Management's peers have been getting more aggressive over the years. In 2008, for example, Republic Services (RSG 0.87%) purchased Allied Waste, the third-largest waste management company at the time, in an effort to better compete against Waste Management. Today, Waste Management remains larger with more than 20 million customers across the U.S. and Canada, however Republic Services is a lot closer than it used to be with more than 13 million customers under its belt. If M&A in the sector continues, it could erode the size advantage that Waste Management currently possesses.
Why Waste Management is trudging higher
Despite these headwinds, Waste Management's stock continues to head higher.
One reason behind the positive price movement is the defensive nature and stability of the refuse collection business that was alluded to earlier. Refuse collection is a necessity for homeowners and businesses; and because it's a necessity Waste Management has no need to reduce its collection prices. Furthermore, because refuse collection tends to be concentrated in the hands of a few larger players, and some markets have no competition whatsoever, it again has little incentive to reduce its pricing to attract new customers. Combined, this strong pricing power leads to inflation-matching or inflation-topping price hikes, which can ultimately boost revenue and potentially its cash flow.
Another key point worth mentioning here is that Waste Management has numerous avenues with which to control its costs and boost its yields. In late July, for instance, the company announced that it would be trimming some of its 43,000 jobs in an effort to cut costs and improve operating efficiency. But, Waste Management can do more to improve its yield beyond just reducing headcount.
2014 Raymond James Industrial & Environmental Services Conference presentation slide. Source: Waste Management.
Waste Management is also converting gases from its landfills to usable electricity to power homes at roughly 130 of its disposal sites. According to statistics from the company, the renewable energy collected from these landfills equates to 550 MW of electricity on an annual basis and can be used to power more than 440,000 homes. Recently, the company discovered a way to harness this gas to power some of its vehicles as well. Waste Management's current goal is to generate electricity from a number of renewable trash sources to power more than 2 million homes by 2020. By maximizing its operating efficiency in this manner it has the opportunity to boost its margins and its profitability.
Lastly, Waste Management's dividend provides a strong lure for investors to buy in and hold on for the long haul. With a current yield of 3.4% and a dividend that's been raised in 11 straight years, Waste Management's payout provides an excellent downside buffer and gives income investors a reason to push its stock higher.
2014 Raymond James Industrial & Environment Services Conference presentation slide. Source: Waste Management.
Will Waste Management shares head higher?
The big question now is whether or not Waste Management's shares will continue higher. The suspicion I have is that it certainly can over the long run given that its business is inherently defensive, and thus better protected from wild volatility swings in the overall market.
I also like Waste Management as a potentially sneaky alternative energy play for the future. The company's ability to harness landfill gases and turn them into energy is incredible, and the possibilities for revenue generation and cost-savings are massive.
All in all, Waste Management's dividend appears sustainable and its stock at a forward P/E of 18 seems reasonable considering that the industry average P/E ratio is also 18. While I can't guarantee with any certainty that the stock will continue higher, I'd certainly suggest you add Waste Management to your watchlist for further research.
