Despite the broad economic impact of the COVID-19 pandemic, Waste Management, Inc. (WM) has done really well through the first half of 2020. As the stock continues to recover from the sharp decline between February and April 2020, the stock has appreciated nearly 30% and currently trades at around $114 at the time of this writing.
Considering that the stock is trading at a relatively high earnings multiple but still below the mid-Feb highs of near $125, the question is whether this is a good price point for entry. My analysis shows that this might be the best entry point we’ll see in the short term.
Thesis: The stock looks expensive at current valuation levels but it’s not, at least not on a relative basis. The factors discussed in this article should help make a strong investment case for long-term investors.
The primary area I’d like to focus on for this article is technology. Not many people would associate a waste management company with advanced technologies, but that’s what sets WM apart from the crowd. What the company refers to as CSD or Customer Service Digitalization will play a pivotal role in a post-pandemic era.
The Positive Impact of CSD on WM’s Future
The CSD platform and, indeed, leveraging technology to increase efficiencies, is not something new at WM. It’s been under discussion for several years. At the Investor Day event in New York City on May 30, 2019, the company outlined its digitalization strategy and how it will transform the business. The strategy itself has been under consideration and has gone through various testing phases in prior years but the pandemic, though negatively impactful on top-line numbers, has allowed the company to inject this strategy with a fresh sense of urgency. As noted by WM president and CEO James Fish at the Q2-20 earnings call at the end of July 2019:
…our customer service digitalization investment otherwise referred to as CSD is unquestionably the right approach. This end-to-end digitalization of our entire customer experience from the first customer contact to the service confirmation will be unmatched and as we’ve seen during COVID-19, the companies with a superior end-to-end online model will truly be differentiated in the post-COVID world.
Spearheading WM’s digital strategy is its Chief Digital Officer Nikolaj Sjoqvist. Since joining the company as VP of Pricing in Feb 2012, he’s moved up the digital ladder at WM, first becoming VP of Revenue Management and, now, Sr. VP and CDO. The reason I bring up Mr. Sjoqvist’s experience with pricing is that WM’s market is an extremely price-sensitive one. Major operators include Republic Services (RSG), Stericycle (SRCL), Casella Waste Systems (CWST), and Waste Connections (WCN), not to mention WM’s recent acquisition target, Advanced Disposal Services (ADSW), the deal for which is expected to be closed in Q3-20.
Although WM is the largest operator in this segment with full vertical integration and a large footprint of facilities, some of them have been growing their revenues at above 7% for the past three years against WM’s own 2.3% CAGR for the period. The scale of the company is one of the reasons for slower growth, but that’s why pricing needs to be aggressive if the company wants to retain its leading market share in this space. The chart below represents each entity’s share of landfill volume as of 2018.
From pricing to revenue management to taking charge of digital initiatives, Mr. Sjoqvist’s vertical experience within the company will help him fine-tune WM’s existing technologies and introduce new projects that will be accretive to the top line and help expand margins through greater efficiencies in how the end-to-end customer experience is managed. His experience with ERP and North American pricing practices carried over from his time at Compaq and then Hewlett-Packard (HPE), as well as McKinsey, make him the perfect candidate to help digitize WM. And this is something that has achieved critical mass during the pandemic.
The Master Plan for CSD
Mr. Sjoqvist’s mandates are clear – cut costs and drive revenue growth. To that end, the company has identified three levers that will accelerate growth and reduce costs. The first of these is risk mitigation and business enablement. By fortifying the technologies underlying the business, the company aims to improve productivity, efficiency, and customer experience. The second lever comprises operational improvements such as collection labor efficiency, asset optimization, automation, and introducing digital tools for employees, all of which aim to expand margins and enable organic growth. The third lever is customer experience, where the company intends to implement end-to-end digital solutions, build a strong eCommerce business, and address specific gaps in how customers currently interact with the company and its services.
That’s the customer service digitalization master plan in a nutshell, but it involves a tremendous amount of work over the next few years. The pandemic has acted as a sort of catalyst to accelerate the effort, which means we could be looking at gains accruing to the top and bottom in the next few quarters. We’ve already seen some of that in Q2-20, during which period the company moved a large chunk of its workforce to the WFH or work-from-home model in the span of a week:
No one within waste management thought we could move thousands of employees to a work from home environment in one week’s time but we did it. This gave us confidence that we can be more ambitious and agile when it comes to technology advances.
Encouraged by its ability to move quickly, the company is now doubling down on its CSD platform integrations and other initiatives. The advantage of moving fast is that problems can be dealt with equally quickly. It also means that the gains will come faster, and that’s what I encourage investors to look for as the company reports Q3-20 and Q4-20 earnings.
To lead us into the next section, I’ll say that the good thing about technology is that a lot of its components lend themselves to measurability. Take digital advertising as an example. Tracking the return on a digital ad is far easier than tracking RoI for a billboard, a newspaper ad, or a TV advertisement because you can track metrics like impressions, click-throughs, conversions, and cost of acquisition per customer. In other words, digital is inherently measurable.
This is one of the major reasons why companies have been shifting their advertising and marketing budgets online – that and the fact that the end user has already shifted to digital – specifically, mobile. Notwithstanding the boycott of the Facebook (FB) advertising platform, which was largely ineffective from a financially punitive viewpoint, advertisers and large corporations have redirected billions of dollars to Facebook because the ad platform is innately capable of targeting users at a micro-level and getting equally granular insights into what works and what doesn’t.
Another example of the quantifiable nature of technology is one that’s more relevant to WM. IBM (IBM) and Ponemon Institute jointly reported that the global average cost of a data breach in 2020 is $3.86 million, and for U.S. companies it was as high as $8.64 million. WM has a large exposure to the residential segment, from which nearly 30% of its collection revenues were generated in Q2-20. That increases its exposure significantly because its systems hold a lot of personal and financial information belonging to homeowners who could potentially sue the company in the event of a breach. That alone might lead to settlements to the tune of millions of dollars. Therefore, investing hundreds of thousands or even millions of dollars into cybersecurity now actually saves even more money in the long run by reducing the threat attack surface and limiting exposure.
Quantifiable Aspects of CSD
There are several other aspects of WM’s operations that can be quantified in the context of technology. As an example, a 1% increase in collection labor force efficiency (Slide 82 of the Waste Management Investor Day Presentation 2019) through data-driven decisions would lead to $25 million in savings, or 8% of WM’s net income for Q2-20, which translates to about $0.05 per share. The initiatives that will eventually lead to such efficiencies were already at play during the second quarter. By reacting quickly to the volume drops in its commercial and industrial segments, WM was able to re-calibrate its operations to nudge its operating margin up by 30 basis points and operating EBITDA by 10 basis points. It doesn’t sound like much but it’s impressive considering the $61 million in impairment charges and several other factors that put additional pressure on margins:
We helped our customers right-size their service levels, temporarily paused price increases, extended payment terms and gave a free month of service to qualifying open market small and medium business customers.
While these actions had a short-term impact on our price metrics, we’ve strengthened our customer relationships and increased customer loyalty. Our customer churn for the second quarter was our lowest on record at 6.9%. We’ve also seen significant increases in our net promoter scores; a measure of customer loyalty. Overall, second quarter net promoter scores increased 82% and our commercial line of business score tripled.
It was an astute move because customer loyalty is far harder to earn than revenue. Per WM, the cost-impact was “relatively immaterial”, but if loyalty is strong, revenue growth will follow. You only have to look at Amazon (AMZN) and how it drove the ‘loyalty economy’ to know that this is a measurable truth.
For WM, it means relatively negligible short-term losses in exchange for goodwill, enhanced loyalty, and higher customer lifetime values. From a long-term perspective, CSD initiatives aim to deliver a similar positive experience across its customer base, increasing satisfaction and loyalty through technological advancement.
A lot of WM’s CSD projects might not be quantifiable right now because they’re just being put into place. One example is the implementation of a new ERP system (Enterprise Resource Planning), another being the full integration of multiple operations into a single CSD platform. The expenses for these were recorded in the Professional Fees line item under SG&A expenses. Despite the drop in revenues, WM saw fit to increase this expense by more than 25%, from $43 million in Q2-19 to $54 million in Q2-20. We should expect to see similar levels through H2-20 as WM rapidly works to create a unified CSD platform and roll out its new ERP platform. How well the company is able to counter this with cost efficiencies will show up in SG&A as a percentage of revenues. The figure currently stands at 10.6% for Q2-20 against 9.9% for the year-ago quarter.
Automation is another point that caught my eye. In general, automation tends to reduce operational costs by between 40% and 75%. To err on the conservative side, I’d put WM’s potential gains at a much lower level. But even if you look at a 20% reduction in operating costs, it would mean a more-than-doubling of net income using Q2-20 figures as an example. $2.2 billion operating costs would be cut to $1.8 billion; assuming other line items remain the same, that’s an additional $400 million straight to the bottom line, or an additional $0.95 per share in earnings.
Of course, this isn’t going to happen overnight. It will take years to arrive at these efficiencies. However, I am confident that the company has picked the right man for the job. As VP of Pricing at WM, he “Led development of WM’s pricing strategy that saw bottom line impact from pricing double from 2012 through 2017.” His approach was, as a technology expert, data-driven, and that’s where the efficiencies are really going to come from.
I predict strong margin expansion at WM on the back of a fully functional CSD platform and other technology-related initiatives over the next few years. Now that WM is doubling down on tech, we could see some meaningful improvement in the next few quarters even as the revenue base recovers.
On the revenue front, the Advanced Disposal Services (ADSW) acquisition, which is expected to close toward the end of Q3-20, will see an additional 3 million customers join WM’s client list, and the associated revenues. Net of the regulation-triggered divestiture of $835 million in combined assets to GFL Environmental (GFL), that should help negate the organic revenue decline because of COVID-19-related shutdowns across its commercial and industrial customer base during parts of Q1-20 and Q2-20.
From a broader perspective, there’s some encouraging news on recovery in the industrial segment. According to the Federal Reserve:
Total industrial production rose 3.0 percent in July after increasing 5.7 percent in June; even so, the index in July was 8.4 percent below its pre-pandemic February level. Manufacturing output continued to improve in July, rising 3.4 percent. Most major industries posted increases, though they were much smaller in magnitude than the advances recorded in June.
Here’s an excerpt from the JOLTS (Job Openings and Labor Turnover) report for June 2020 released by the Bureau of Labor Statistics that acts as an indicator for commercial recovery:
The number of job openings increased to 5.9 million on the last business day of June, the U.S. Bureau of Labor Statistics reported today. Hires decreased to 6.7 million in June, but was still the second highest level in the series history. The largest monthly increase in hires occurred in May 2020. Total separations increased to 4.8 million. Within separations, the quits rate rose to 1.9 percent while the layoffs and discharges rate was unchanged at 1.4 percent. These changes in the labor market reflected a limited resumption of economic activity that had been curtailed in March and April due to the coronavirus (COVID-19) pandemic and efforts to contain it.
As the economy hobbles back to some level of normalcy, the gradual resumption of economic activity should show up in WM’s revenues. The revenue decline in Q2-20 over the prior period was recorded at around 10%. This is the first time in several years that WM has had a YoY decline in quarterly revenues, and the measure of decline speaks to the company’s resilience to the pandemic as well as the diversity of its operational segments. As businesses and industrial units continue to reopen through Q3-20, we should see some meaningful revenue gains on a sequential basis. FY-20 revenues are still expected to show a decline over the prior year, but it’s clear that the management team has various parts in place to minimize the impact.
Source: Seeking Alpha
Coming to the question of valuation, a forward P/E of 30 might seem high for a company with a 5-year revenue CAGR of under 2.5%. However, on a relative basis, WM’s multiples are generally in line with its peers, based on each company’s respective historical revenue growth, forward revenue growth expectations and historical earnings.
That’s where the technology upside plays a critical role. As WM realizes margin gains from CSD and other tech-related initiatives, these same multiples will translate into a higher price for the stock. The FY-21 EPS estimate of $4.24 at a 29x earnings multiple gives us a price of around $123 for an 8% upside to the as-of-writing price of slightly over $114. By my estimates, even that is a relatively conservative outlook. Judging by the efficiencies it can create by then and the fact that revenues will have resumed their low single-digit growth cadence, I see the current price as a reasonable entry point. There will be no share repurchases for a while but WM has the required free cash flows to continue growing its dividend.
As for risk, there aren’t that many predictable headwinds for the segment as a whole. The economy will eventually see normal levels of commercial and industrial activity, which will put in on a revenue growth path again in FY-21, albeit at possibly lower levels than FY-19. In the meantime, the technology-driven margin expansion should start showing up in the next few quarters, helping support the stock price at similar forward earnings multiples.
WM is a buy based on the above analysis, and I would encourage investors to look at holding the stock in their portfolio over a long-term horizon, and as a buffer for other, more volatile companies they may be holding at the moment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.