Next to gold, Bitcoin, and NASCAR-themed commemorative plates, garbage might not seem like a terribly exciting investment. But with the right roadmap at your side, you can find plenty of treasure among the trash. If you're interested in investing in the waste hauler industry, you'll want to know the right way to measure their merits. At The Motley Fool, we're big fans of using investment checklists to help us make smarter decisions about stocks and avoid unforced errors. Here's a checklist covering five key areas that can help you find better stocks in the waste management industry.
1. The assets
They might not make for great desktop backgrounds or scratch-and-sniff cards, but landfills are amazing for turning trash into cash. Though expensive to build, these assets can generate steady revenue for years or even decades to come.
But not all dumps are created equal. And just like vacation homes, it's all about location, location, location. Because trash isn't terribly valuable, companies and cities won't ship it long distances, which gives local landfills a stranglehold on nearby markets. Consider whether a company's landfills are located near growth areas -- like booming cities, promising oil fields, or stalwart industrial centers. Companies usually include a map of their locations in investor presentations, or a list of their properties in aptly titled "properties" section of their 10-K.
After location, look at how much capacity the company's existing landfills have left -- and whether they'll need to add capacity soon. Expanding a current landfill -- or building a new one -- is expensive and requires regulatory approval that can take years to obtain.
This is even more important for specialized waste handlers, like US Ecology (NASDAQ:ECOL). There's a good reason nobody has opened a new hazardous-waste dump in 10 years and why there are only 20 in the U.S. today. Doing so is a royal -- and costly -- pain in the backside.
There's an upside, however. US Ecology owns four of those 20 U.S. hazardous waste dumps, which gives them 20% of the nation's capacity. This has helped them keep prices high, demand flowing, and return on invested capital above 13%, during eight of the past 10 years.
2. Looking downstream
You'd think the waste management industry would be as regular as your weekly trash pickup, but it's more cyclical than you might think. Most handlers are paid by volume. The more we buy -- and the more we throw away -- the more revenue dumps generate for their owners.
Figure out what type of customers the company serves, and how these customers should fare over the coming years. For plain-vanilla municipal waste haulers, like Waste Management, look at trends in retail sales and construction. For hazardous and industrial waste companies, like US Ecology, volumes closely track the industrial production index.
Next, consider whether the company can add new waste streams to its existing assets. Different types of hazardous waste, for instance, require different permits. Adding new ones can diversify a company's customer base across multiple industries, which smooths out revenue across the cycle
A more cyclical customer base shouldn't be a deal-breaker for your investment thesis, but it should make you more skeptical about past growth trends. Did they come from legitimate expansion or a cyclical uptrend?
3. A clean track record
Even with trash, you want a company that's squeaky clean. Waste management is heavily regulated, and a few major run-ins with the EPA can be a big problem. Remember, these companies need government approval to operate and expand, so ticking off the people granting that approval is a less-than-stellar idea. They can make it tougher to renew existing permits or add new ones, hampering growth.
You can be more forgiving when looking at colossus like Waste Management, but for smaller players, one big accident can derail an investment thesis.
4. Rotten growth
Most of the financials analysis investors use for other companies apply to the waste management industry, but there are a few red flags you should be particularly careful about.
As with other industries, waste management companies are under constant pressure to grow revenue -- often at any cost. Because landfills are so darn expensive to build, this "any cost" can be so high that it isn't worth the trouble, and many large operators are focusing on acquisitions -- buying up assets from smaller operators in the hopes of earning a return through greater scale.
This can be a profitable strategy when done correctly. But you should be on the lookout for goodwill impairments, a sign the company has overpaid for acquisitions in the past. Furthermore, revenue growth numbers are far less informative for this industry than return on capital. If goodwill impairments are common and return on capital is dropping, steer clear, even if the revenue growth numbers look good.
5. Putting a price on garbage
Though the waste management industry is all about assets, metrics like price-to-book aren't terribly informative because the landfill assets are rarely priced properly on the balance sheet. Further, heavy investments and depreciation of long-lived assets can skew earnings, making the P/E ratio fairly useless. The best short-cut valuation method for this industry is the EV/EBITDA ratio, which compares a company's enterprise value (EV) to its earnings before interest, taxes, depreciation, and amortization (EBITDA).
Try comparing the company's current ratio to its own history and to similar businesses in the industry. When analyzing a more cyclical part of the industry, try normalizing EBITDA by multiplying current revenue by the company's five-year-average EBITDA margin. This will help you understand how much of the current price is based on business quality -- and how much is based on a cyclical upswing.
Foolish bottom line
Waste management isn't the sexiest industry in the world, but don't throw it out simply out of boredom. If you know where to look -- and what to look for -- you could make a lot of cash investing in trash.
Frank Thomas owns shares of U.S. Ecology. The Motley Fool recommends and owns shares of Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.