Trash Stocks Trashed: An Income Opportunity?
Dumpster diving for high yielding gems.
An earlier version of this article was written at the end of July and published on my Forbes blog, before the August market implosion. I've updated it here to reflect the new stock prices and some recent company news.
Renewable energy has many advantages over fossil energy. One of the most important is that it's renewable. As supplies of Oil and other fossil fuels are used up, they become harder and more expensive to extract, while renewable energy is generally getting cheaper over time, due to improving technology.
Unfortunately, while there is no real limit to how expensive fossil fuels might become, as we start using more and more renewable energy, we will start running into resource constraints which will eventually end the decline in renewable energy prices. Where fossil energy uses a small capital investment up front, followed by a long tail of fuel cost, renewable energy requires a large capital investment up front, followed by little or no fuel cost. Unfortunately, that up-front capital investment is not just money: it's an investment in capital equipment such as solar panels or wind turbines using much more raw material than an equivalent fossil fuel plant.
Commodity prices are already high and rising higher because of buoyant demand in developing countries. The transition to clean energy will only accelerate this trend, as old fossil fuel based generation is replaced with new renewable energy that require a far larger investment of industrial metals. This is what Jeff Vail calls the Renewables Gap, and John Petersen calls the Alternative Energy Fallacy. We cannot transition to clean energy without making other significant changes to our economic system: the resources in energy and raw materials are not there. In reality, we must make those changes, because we simply do not have the resources to transition to clean energy while continuing business as usual.
Commodities and Trash
Rising commodity prices have recently been hurting waste haulers even as volumes fall during the recession. On July 28, Waste Management (WM) missed Q2 Earnings expectations by $0.12, earning $0.50 per diluted share. Waste Management's CEO, David Steiner, attributed a $0.04 earnings shortfall to increased operations and maintenance due to rising commodity prices in the earnings call, yet "[h]igher commodity prices, improved recycling volumes, acquisitions and year-over-year yield increases contributed to the [year over year] revenue growth." Overall volumes dropped due to a slower economy, and management attributed a decline in revenues to this, in addition to increased competition.
The other side of rising commodity prices is not a cost, but a revenue source. This comes in two forms: Recycling and Waste-to-Energy. Waste Management is expanding in both these areas, with significant waste to energy operations, which benefit from rising energy prices, and recycling operations, which benefit with rising prices for recycled paper, plastics, and metals.
While Waste Management has fallen from around $36 to below $30 (17%) because of the earnings miss and market decline, another waste and water purification stock I follow, Veolia Environnement SA (VE) has been much worse hit, falling from $26 to $15 (42%) because of lower guidance related to restructuring because of declining volumes, plans to downsize, and an accounting fraud in its US division. Veolia has been hit by declining volumes and increased competition in the US, as well as European economic woes.
Yet both Waste Management and Veolia are high yielding companies, and are beginning to look tempting to income investors as dividend yields are pushed up by declining stock prices. Unfortunately, Veolia's restructuring could easily lead to a dividend cut since the company already distributes most of its earnings to shareholders in the form of dividends, and this could lead to a further fall in the stock price, if it is not already priced in.
Progressive Waste Solutions (BIN) also missed second quarter earnings, a shortfall the company blamed on bad weather. The stock fell further than many others in the recent sell-off because much of it's revenue comes from Western Canada, where the economy is heavily dependent on the oil fields. But I seriously doubt that oil price declines will come anywhere near the levels needed to seriously dent the oil sands boom, so investors' fears over oil seem to be providing a buying opportunity in this stock, as outlined in a recent Barron's article.
The downtrend in waste stocks has been industry-wide, with the Global X Waste Management ETF (WSTE) having declined 18% over the last three months, while the S&P 500 index has declined less than 15%. This under-performance is surprising in an industry which is often considered a defensive play.
Safe Income From Trash?
While I'm tempted by the high current yields, I want to be sure that the companies can easily cover their rather high dividends with earnings going forward. I'd like a stock with a high dividend yield, but with that dividend well covered by earnings and Free Cash Flow (FCF). I'm also looking for a low leverage ratio (debt to equity,) so that the effects of any future decline in revenues will have only a moderate effect on earnings. Below, I show dividend yield compared to three years of earnings yeilds and estimates as well as trailing FCF yield and debt to equity ratios for several waste management stocks.
As long as earnings and FCF yields are comfortably higher than the dividend yield, the company in question should be able to continue to pay (or even increase) the dividend.
|Stock||Price||Dividend||2010 EPS||2011 Est||2012 Est||FCF||Debt/Equity|
|Waste Management (WM)||$29.40||$1.36||$2.10||$2.14||$2.44||$2.04||1.38|
|Casella Waste (CWST)||$4.81||$0.00||$0.24||-$0.50||$0.09||-$0.13||4.95|
|Republic Services (RSG)||$27.50||$0.80||$1.71||$1.88||$2.13||$2.25||0.87|
|Progressive Waste (BIN)||$20.91||$0.51||$0.94||$1.12||$1.30||$1.54||0.79|
|Waste Connections (WCN)||$30.99||$0.30||$1.24||$1.48||$1.71||$1.74||0.83|
As I noted earlier, while Veolia has an attractive yield of almost 10%, but with earnings and Free Cash Flow yields only slightly higher, and FCF far below, Veolia will probably have trouble maintaining its dividend if the fierce competitive environment and low waste volumes persist or worsen, with 84 cents of every dollar earned being paid out as dividends. With a Debt to Equity ratio of almost 200%, the company is quite vulnerable to further drops in revenue, although they may be able to pay off some of this debt by selling divisions as part of the downsizing.
Waste Management's dividend payout is also higher than I would like at 64% of earnings and 67% of free cash flow, but the lower debt to equity ratio makes this more manageable, so I expect they will be able to maintain the current dividend.
Of the other companies listed, both Republic Services and Progressive Waste are beginning to look attractive because their lower dividends (at 3% and 2.5%) are very well covered by earnings and cash flow, and their low debt means that earnings will be more resilient in the face of a potential continued revenue decline. On the other hand, if earnings continue to grow as projected, these two companies have plenty of room to increase dividends further.
The falling volumes and increased competition in the waste management industry, along with the last few week's market decline have made these stocks into attractive income investments. Since the sector has a reputation for earnings stability, the recent earnings misses and revisions have hit investors particularly hard, leading to potential buying opportunities. Nevertheless I feel there is still room on the downside, so it's probably better to dip a toe into the trash bin rather than engaging in full scale dumpster diving.
The most attractive names right now are Waste Management and Republic Services, while Veolia's gigantic dividend will tempt braver investors, and Progressive Waste is probably worth including in a portfolio for additional diversification. I have a bias toward Waste Management and Veolia because they have stronger focuses on recycling and waste-to-energy, which I believe will serve them well if commodity and energy prices continue to rise due to growth in emerging economies.
DISCLOSURE: Long WM,BIN.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.