Waste Management Stock: Strong Underlying Results Merit A Premium Valuation (NYSE:WM)

Waste Management (NYSE:WM) shares have been treading water over the past year, up just 2% as the business continues to perform well but valuation has been elevated, particularly in light of higher interest rates. The company recently reported Q3 earnings, which were solid, despite some headwinds in recycling. Since recommending shares last October, Waste Management stock has returned about 5%. While the stock is not cheap, I believe it merits its premium valuation and that patient long-term investors can be rewarded with 8-10% long-term returns.

In the company’s third quarter, Waste Management earned $1.63 in adjusted EPS, beating consensus by $0.02 as revenue rose by 2.4% to $5.2 billion. EBITDA margins increased by 100bp to 29.6% in the quarter, which is why earnings rose 5% from last year. WM is showing really solid pricing power, which is helping to recover lost margins. Core price was up 6.6%, on top of the 8.2% rise last year for 15% 2-year growth. This was 100bp ahead of cost inflation. In 2021 and into early 2022, WM was struggling to find workers and faced significant wage inflation, which squeezed margins. Now, the jobs market is slowing, investments in automation are paying off, and it continues to raise prices, bringing results onto a stronger footing. Overall, collection and disposal yield was 5%.

Because of moderating labor costs and increased automation, operating expenses were down 90bp to 61.3% as wage pressure moderates. We have now likely seen most of the margin expansion in its core waste collections and landfill business occur, with some more marginal gains in 2024 likely. Volumes rose by 1%, adjusted for the number of workdays in the quarter. While the majority of WM’s business serves households and business, construction site collections is an important contributor to volume trends. Over the past year, residential construction has slowed as homebuilders pulled back in the face of higher interest rates.

This headwind appears to be fading. As you can see below, residential investment is showing signs of stabilizing, actually rising 4% annualized in the Q3 GDP release. I am not arguing that residential investment is about to return to 2021 levels, rather the headwind this has presented for volume growth should be largely past Waste Management by now. We actually may see construction be marginally accretive to volumes as we move into 2024.

While the core business is performing well, WM is seeing some headwinds from recycling. Recycling EBITDA was down $10 million from last year, given a 40% decline in prices. Recycled commodity prices were $58/ton from $94/ton last year. Alongside this, its growth renewable unit saw EBITDA fall $13 million given lower energy prices. Renewable fuel credits were $2.65 from $2.85 as natural gas prices averaged just $2.11 from $7.21 last year.

Frankly, these declines in earnings are quite impressive given the magnitude of the pressure Waste Management faced from lower prices. As you can see below, revenue from these units fell 23% or $108 million from last year. Combined recycling/renewables EBITDA was only down $23 million, meaning it was able to offset nearly 80% of this revenue decline with offsetting cost pressure.

As I wrote about last year, WM fundamentally changed its recycling pricing model back in 2018 to reduce its exposure to commodity prices by generating more revenue from the collection of recycling. This 40% decline in prices is now just a $0.06-0.08 full year EPS impact; it had been $0.20 before the action taken in 2018. WM has also been increasingly automating recycling facilities, taking more cost out of its operations. Two more facilities will be on-line in Q4, further reducing this headwind.

I also think it is important here to note that while revenue growth was just 2.4% at the consolidated level; its core business is rising 5%. Much of the revenue fluctuation in renewables/recycling is commodity price related, which is being largely offset on the input cost side, as seen by its relatively low EBITDA impact. We will see overall revenue growth re-accelerate over the next year as easier comps occur in these two businesses.

Management also reiterated that it expects its sustainability investments to bring in $740 million of incremental EBITDA by 2026, with one-third of that coming from recycling. This will power an additional ~10% of growth to the company’s run-rate EBITDA. WM is using waste at its landfill to create renewable natural gas, using that as a fuel to power its trucks. This value of not having to buy natural gas on the open market will of course move with prices. As it continues to build scale, it will be able to sell more fuel externally, turning this business not just into a cost-saver but an incremental revenue producer.

During the quarter, WM had free cash flow of $612 million after $180 million of sustainability-linked cap-ex on top of its ongoing cap-ex needs. WM has generated $1.62 billion in free cash flow this year, net of working capital, leaving it on track to deliver about $2.2 billion over the calendar year.

WM Is returning this free cash flow fully to investors. So far, it has done $990 million in buybacks, and its dividend has cost $855 million, for a combined $1.8 billion of capital return. In Q4, I expect another ~$300 million to be repurchased, and these buybacks have reduced its share count by about 2% over the past year.

Over the next two years as it completes its sustainability-linked cap-ex, we should also see the free cash flow profile of the business improve. In the meantime, WM is returning just a bit more to shareholders than total free cash flow, essentially using a bit of debt funding for growth projects. Debt is up slightly to $15.4 billion from $15 billion. It has the balance sheet strength to do this. It has a 2.73x debt-to-EBITDA leverage at the mid-point of its 2.5-3.0x target.

Importantly, its debt is 91% fixed rate, and it has just a 3.9% average cost. The majority of its debt matures after 2027, and WM issued $2 billion in debt in July to manage the 2023 maturities it had. Refinancing needs are modest over the next three years, meaning the need to borrow at higher rates will have a minor impact on its free cash flow.

For the full year, WM is poised to earn $6.05 in EPS. This is a bit below my $6.10+ expectation when I wrote about Waste Management last year as the recycling and renewable businesses have dragged. That said, given the magnitude of the price declines, to be just $0.05 below my estimate is a testament to how much WM has de-risked this business from commodity prices. I do not think investors should let these cyclical commodity price fluctuations outweigh the core ongoing strength of the collections business, the persistent pricing power it has, and the fact that over the medium its green energy projects will be a meaningful source of cash flow.

Shares today have has a 3.4% free cash flow yield, but they are about 4.5% ex-sustainability investments, which will begun to slow in 2025/2026, allowing free cash flow to accelerate.

Assuming flat energy and recycling prices off of the current depressed levels, and a modest pick-up in volumes from construction, I expect WM to grow earnings 8+% next year as top-line growth continues to run about 5% in the collection business. With the share count likely to keep falling at about 2%/year, that should power about 10% earnings growth to $6.65-6.75 with about $2.3-2.4 billion of free cash flow.

I continue to target about $170-175 for shares, or about a 3% free cash flow yield, given the long-term 5-8% growth of the business, enhanced by the ramping sustainability income. Additionally, as we should see further acceleration in free cash flow as these projects fully contribute to results. WM trades at a premium, but these results, and its ability to generate long-term compounded growth, merit a premium. While WM is not a “get rich quick” stock by any means, it is a steady grower that will reward patient investors.