This summer, Waste Management's "Junkheap" front-end loader debuted in the movie "Transformers: Age of Extinction." Have transformative business decisions also taken place at WM in 2014? Image: Waste Management,
Waste Management's (WM 0.79%) first half of 2014 was highlighted by the announced sale of its Wheelabrator Technologies waste-to-energy business this summer. During the company's second-quarter earnings call at the end of July, management discussed the rationale for the sale, as well as other salient points that are driving WM's business. Below is a condensed guide to the earnings call, with five key ideas management sought to communicate.
1) The Wheelabrator sale will mean a bit less income, but it's a solid business decision
"[W]e will no longer have the volatility of the financial results related to Wheelabrator electricity sale." -- CEO David Steiner.
At $845 million in sales, Wheelabrator represented about 6% of Waste Management's total 2013 revenue of $14 billion. The company earns money from Wheelabrator in two ways: It collects fees to haul waste to Wheelabrator's plants, which use combustion to create and sell "clean, renewable" electric energy. Waste Management has retained the waste-hauling portion of the business, while selling the waste-to-electricity plants to Energy Capital Partners for $1.94 billion.
Wheelabrator has affected WM's bottom line in the same magnitude as revenue. The company will have to replace roughly $220 million, or 6.6%, in annual EBITDA, or earnings before interest, taxes, depreciation, and amortization, from the sale of Wheelabrator. It will seek to do so gradually via what Steiner termed "smaller, tuck-in acquisitions."
Management believes the sale makes sense at this time. Last year, several long-term, fixed-price electricity contracts expired, increasing the volatility of Wheelabrator's revenue and income. And at the end of 2013, Waste Management took a $483 million goodwill impairment charge against the Wheelabrator business, due to economic weakness in the regions in which it operates and lower commodity prices for electricity due to the boom in natural gas.
2) We're not going to sacrifice pricing for volume
"I don't think there is any doubt that in the last 12 months to 18 months we've seen some of our larger competitors favor volume over price. That's not something that we traditionally have done and obviously that has cost us volume." -- CFO Jim Fish.
In the "slow but steady" category of corporate growth, Waste Management has recorded five consecutive quarters of collection and disposal yield above 2% as of the second quarter of 2014. Yield on collection and disposal activities is a sales growth measure that includes both price increases and services mix, irrespective of volume. For the last few quarters, WM has fought a declining volume trend that has offset gains in yield -- leading to second-quarter 2014 revenue growth of just 1%.
However, by concentrating on yield, in conjunction with tight discipline on operating costs, WM saw a 9.8% year-over-year increase in operating income over the first two quarters of 2014.
On the call, company management cited a 5.1% increase in municipal solid waste landfill pricing as an example of its strategy to continue raising collection activity pricing in the second half of 2014. The message here is fairly simple: Management would rather have less revenue with higher profits than higher revenue with slimmer margins.
3) We lost some national accounts during the quarter, but we're not worried
"More than 50% of our volume decline came from several low margin, but large national account losses." -- Steiner.
This theme is directly related to point No. 2 above, and two facts are relevant in this context. First, Waste Management's book of business is extremely well diversified: According to the company's annual 10-K filing, WM's largest customer accounted for less than 2% of total revenue in 2013.
In addition, as Steiner pointed out in the call, the largest account lost during the quarter had a "low single-digit" margin. Thus, the profit margin on the lost account was 5% or less. Given the company's 14.4% operating income margin in the first half of 2014, such an account -- and others like it -- more likely drag on earnings than contribute meaningfully to net income.
4) A housing recovery is still vital to our business
Residential recycling accounts aren't the only revenue stream that opens up when housing recovers. Image by keepingtime_ca under Creative Commons License.
"You absolutely need to see a sustained housing recovery to see a robust commercial volume recovery." -- Steiner.
This statement might not be intuitive to those who don't follow the waste industry very closely. The CEO pointed out that a true housing recovery provides the support for commercial volume increases at Waste Management. Housing expansion in new areas attracts the gas stations, shopping centers, and other businesses that become commercial customers of Waste Management and its competitors. Steiner indicated his belief that housing is indeed recovering, although the impact will be felt more in 2015 than 2014.
5) We're mindful of our leverage, and will keep it in check
"[W]e would selectively retire debt to the extent necessary to maintain our strong balance sheet and our target leverage ratio of about three times EBITDA." -- Fish.
Over the last five years, WM's borrowings have crept up about 30%. While the company's total balance sheet has increased, as you can see from the chart below, debt is growing slightly faster: Waste Management's debt-to-equity ratio has followed the debt expansion during the time period.
WM Debt to Equity Ratio (Annual) data by YCharts.
Management strives to maintain total debt at no more than three times EBITDA. As mentioned at the outset of this article, the sale of Wheelabrator will reduce annual EBITDA by about $220 million, impacting this formula. While it will take some time to rebuild those earnings, the company intends to use some of the cash proceeds from the sale to reduce debt -- a way to attack the debt-to-EBITDA formula from the other side.
How is the company doing on its goal of operating at no more than three times earnings to debt? If you annualize EBITDA through the first two quarters of the year (adjusted for nonrecurring items), you'll see that Waste Management is right at its target limit: The company's $9.7 billion in debt is roughly three times its $3.3 billion in EBITDA.
A final note on this topic: Waste Management's debt covenants call for a maximum debt-to-EBITDA ratio of 3.75, decreasing to 3.5 after Sept. 30, 2015. Thus, at current income current levels, WM could add $1.5 billion of additional debt to its books by this time next year. However, based on management's present guidelines, it would take an unexpected circumstance -- say an acquisition opportunity -- for executives to consider using any more of the company's borrowing capacity.
