Waste Management (NYSE:WM) stock has so far enjoyed a credible, if not stellar, 2014, inching ahead of the S&P 500 Index's year-to-date gain of 8% by roughly 0.75% on a total return basis. While the company has posted solid earnings through the first two reported quarters of 2014, risk factors abound nonetheless. Investors who follow this waste-hauling giant may want to keep the following three risks in mind.
1. The company's price-versus-volume bent may hurt in the short term
A characteristic of Waste Management's business strategy is its tendency to raise prices on customers, both during the term of contracts, in the form of annual escalations, and at contract renewals. Management clearly favors higher yields on its business segments versus gains in volume, as illuminated in this quote from CEO David Steiner:
As we've said in the past, we're not focused on getting the most volumes; we're focused on getting the best volumes. We're looking for the best mix of yield and volume to drive income from operations, dollars, and margin.
This is precisely the type of strategy investors should favor, as it's oriented toward a healthier long-term profit and loss statement. But at least in the near future, holding firm on pricing for significant contracts could lead to contract loss and pressure on the company's top-line revenue -- especially as opportunistic competitors gun for the company's customer relationships.
The risk is that with the incremental increases in quarterly revenue seen over the last couple of years, even moderate contract breakage could translate into earnings misses, pressuring the company's stock.
Waste Management's business is extremely well diversified among customers -- no customer makes up more than 2% of company revenues, according to Waste Management's latest annual report. Still, last quarter, Waste Management lost two profitable residential contracts, as well as a few less profitable national account contracts, so shareholders should peruse conference call transcripts for the next couple of quarters for updates on any further contractual slippage.
2. Keep an eye on the CPI
That an expanding economy is important to the fortunes of companies like Waste Management seems obvious, but there's a more subtle correlation to economic activity which directly affects WM's performance: the strength or weakness of inflation. Many of the escalations I mentioned for Waste Management's residential, commercial, landfill, and other contracts are based on the CPI, or Consumer Price Index, a broad measure of inflation. When inflation rises, Waste Management's contracts are adjusted upward, improving the yield on its business.
Typically, when economic activity accelerates, inflation tends to climb, as demand for goods and services increases faster than the available money supply. In the current economic recovery, however, the Federal Reserve's monetary policies appear to have muted the impact of inflation. In fact, the trend in the "All Cities" CPI measure, reported monthly by the Bureau of Labor Statistics, stands at 1.7% for the year so far, a very modest increase.
While Waste Management's contract renewals are likely based on subsets of the All Cities CPI index, this top-level gauge gives investors a good picture of the rather lukewarm inflationary environment the company currently faces. Management has named CPI as a headwind in its business for the past several quarters.
3. Wheelabrator revenue and margin may be harder to replace than it seems
In July, Waste Management announced the sale of its Wheelabrator energy business to Energy Capital Partners for close to $2.0 billion. On the company's earnings conference call, CFO Jim Fish outlined some of the benefits of the deal: Waste Management will receive $1.85 billion in cash, pay no tax on the transaction, and enjoy a capital loss carryforward of $300 million, to be utilized against future tax liabilities over the next five years.
As we discussed in a previous article, the company will also lose about 6% of its revenue, and $200 million, or 6.6%, of earnings before interest, taxes, depreciation, and amortization (EBITDA). The company plans to replace the lost earnings through small acquisitions, potentially using some of the proceeds from the deal.
There may be room here for the company to stumble, in that if one examines the recent trend of WM's EBITDA quarter by quarter, it's apparent that the waste conglomerate has had difficulty growing earnings over the past five years, exhibiting what's essentially a flat trend:
The outlying dip in the fourth quarter of 2013 includes approximately $483 million of one-time charges the company took to write down the value of its Wheelabrator business. Incidentally, if you're confused by Waste Management's seemingly sky-high P/E ratio of 178 times trailing-12-month earnings, this one-time charge is the culprit: By depressing earnings, it may give the appearance that the stock is overvalued. Adjusting for the $483 million (without regard to tax effects), we find a P/E ratio closer to 37, in the ballpark at least of the recent historical average of 18 times earnings.
The problem Waste Management may face is that despite a culture of cost reduction, as revenue growth has moderated, it's proved difficult for the company to expand earnings. Management intends to replace Wheelabrator earnings through acquisitions, yet in the near term, acquisitions can to lead to higher costs. There are the initial transaction costs to consider, and depending on the company, it can take some time for Waste Management to bring an acquisition in line with its own efficient operating metrics.
Revenue increased nearly 2.5% between 2012 and 2013, but through two reported quarters of 2014, the top line has grown only 1.4%. Thus, if revenue growth continues to abate, and if it takes some time for the company to replace Wheelabrator earnings, then EBITDA, as well as unadjusted earnings, could suffer slightly.
Asit Sharma has no position in any stocks mentioned. 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.