Last week I outlined my plans to create a portfolio of 10 companies that all have one thing in common: They provide a basic need or deliver life's necessities. It's my contention that basic-needs companies can offer investors stability and growth throughout any market environment thanks to consistent demand, incredible pricing power, and delectable dividends. This portfolio, which I have dubbed the Basic Needs Portfolio, will be pitted against the S&P 500 over a period of three years with the expectations of outperformance for all 10 stocks. I'll be rolling out a new selection to this portfolio every week for the next nine weeks.
Today, I plan to introduce the first of 10 selections to the Basic Needs Portfolio: Waste Management (WM 0.06%).
How it fits in with our theme
Waste Management fits the theme of the portfolio in actually more ways than one. Obviously, trash collection is a basic necessity that's needed regardless of whether the economy is booming or in a recession. The amount of trash we generate may fluctuate slightly based on the health of the economy, but hauling it away remains a basic need that creates consistent cash flow for Waste Management.
However, Waste Management also tackles numerous other basic needs such as energy generation and recycling. You might scoff at the idea that recycling is a basic need since it's an optional act by Waste Management's customers, but the discount incentive provided by Waste Management to customers who do recycle, and the positive benefits of being able to reuse limited resources, makes it a basic need in my book.
Also, Waste Management is able to harness biogas and methane from its landfills to fuel its refuse collection vehicles and generate 550 MW of electricity, which can be used to power more than 400,000 homes.
Fuel and electricity might as well be considered necessities, which make Waste Management a perfect first selection.
As with all stocks, there is no such thing as a riskless investment. For Waste Management, the two biggest risks are industry consolidation and a precipitous drop in metal prices.
Looking at this in reverse, high metal prices help drive returns in the company's recycling business. It certainly isn't cheap to set up recycling operations and employ hundreds of people to weed out what careless individuals have thrown in the recycling bin that doesn't belong there, so it helps if metal prices are doing well. Lately, that hasn't been the case. Weaker GDP growth in China and stringent austerity measures in Europe have reduced demand for most metals across the board and allowed spot prices to sink, ultimately hurting Waste Management's recycling business. Unsurprisingly, average recycling prices in the first quarter were down 12% from the year-ago period.
Keep in mind, though, this is a sectorwide problem, not just one affecting Waste Management. Canada's Progressive Waste Solutions (NYSE: BIN) delivered an 11% increase in first-quarter revenue but succumbed to a decrease of 0.5% in recycling revenue because of lower realized metal prices.
Competition also stands to be a big threat. Waste Management's success has a lot to do with its size. Being bigger than its peers gives it more visibility in the public eye (let's face it; there aren't too many garbage collection services to choose from) and allows it premium pricing power relative to those peers. Republic Services (RSG -0.10%), Waste Management's largest rival, is doing what it can to compete by having purchased Allied Waste in 2008 -- at that time the nation's third largest waste company.
Other players in the field, such as Waste Connections (WCN -0.12%), have viewed traditional refuse collection as too crowded and have looked toward unique ways of boosting their bottom line. Waste Connection last year purchased R360 Environmental Solutions for $1.3 billion to get a foothold in the oil and natural gas industry. R360 generates revenue by cleaning contaminated fields, recovering oil from storage tanks, and washing drilling facilities.
Why Waste Management?
Risks aside, there are a lot of reasons to like Waste Management. For one, the company is socially responsible and vertically self-sufficient. It collects refuse, recycles some of that refuse for future use, and uses methane and other gases from its landfills to power homes and its fleet of collection vehicles. The company has come full circle with regard to internalizing its costs and making the most of each pound of trash collected.
Another factor that easily puts Waste Management on top in the waste-collection sector is its dividend yield of 3.4%. The only company with a higher yield is global waste solutions company Veolia Environnement (VEOEY 0.65%), with a 6.2% yield. However, Veolia also boats a higher debt-to-equity ratio than Waste Management, has unwanted exposure to European markets, and has lower overall margins relative to Waste Management. By comparison, Republic Services, Progressive Waste, and Waste Connections pay out a yield of 2.7%, 2.4% and 1%, respectively. Even better, Waste Management's payout has grown by an average annualized rate of 7.7% since 2004.
Finally, it's all about the cash flow. Waste Management has averaged $1.1 billion in free cash flow from operations each year over the past decade, which has allowed for share buybacks, which have reduced the outstanding share count by nearly 22% and obviously allowed its dividend payout to roar higher. Furthermore, this cash flow allows Waste Management to reinvest in newer technologies capable of harnessing more fuel from its landfills and should allow it to double its electrical output to homes within the next decade.
Stay tuned next week, when I'll unveil the second selection to the Basic Needs Portfolio.