Waste Management Gets Dumped

Seven seems an unlucky number this week. After reporting earnings on Thursday, Motley Fool Hidden Gems recommendation Columbia Sportswear (Nasdaq: COLM  ) saw its stock fall 7%. Next door and a day later at Motley Fool Inside Value, recommended stock Waste Management (NYSE: WMI  ) suffered the same fate, after reporting its own Q3 numbers.

The twin declines stemmed from different sources. Columbia's profits looked just fine; its stock suffered from disappointing guidance. But at Waste Management, the news disappointed.

CEO David Steiner noted that the firm encountered a "5.0% reduction in volumes in the third quarter." But this was not "the primary driver" behind the quarter's declining profit. Instead, Steiner blamed a strike among workers in Oakland, Calif., for costing the firm $0.03 per share. Also at fault: a spike in oil prices that axed anticipated "Section 45K" tax benefits from the firm's alternative energy programs. (Take note, investors in Headwaters (NYSE: HW  ) , which reports Nov. 6, and Rex Stores (NYSE: RSC  ) , which reports in December.)

The good news is that operationally, things worked out pretty well at Waste Management last quarter. Operating margins expanded as management succeeded in compacting 40 basis points worth of operating costs. Taking a page from the same playbook that firms as varied as American Woodmark (Nasdaq: AMWD  ) , ChoicePoint (NYSE: CPS  ) , and Apogee (Nasdaq: APOG  ) follow, Waste Management cut costs by culling low-margin operations. Whether by dropping unprofitable accounts or jacking up prices until they become profitable, Waste Management is doing an admirable job of "managing" its costs to avoid "wasting" effort.

Digging for valuation
Free cash flow totaled $550 million in the third quarter, leading management to up its annual guidance here by a cool $100 million. Waste Management now expects to generate $1.5 billion in free cash flow by year's end. If the company hits that target, we're looking at a firm valued at a little less than 13 times current free cash flow, and expected to grow its profits about 10% per year over the next five years.

In my opinion, that's not a great valuation. I'd much rather see a price-to-free cash flow ratio of less than 1.0. Still, the average S&P 500 company currently trades for closer to 1.4. The worst you can say about Waste Management is that while it's a bit expensive in its own right, it's still selling at about a 16% discount to the market.

And what's the best we can say about Waste Management? Well, the deep value seekers at Motley Fool Inside Value will tell you that they think Waste Management's share price offers as much as a 26% margin of safety. To find out why -- and more importantly, how much they think you should pay for the shares -- try out the service free of charge.


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