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Morningstar | IT Investment Rising, but Waste Management’s 1Q Collection Volume Remains Strong; Shares Rich

Wide-moat waste services leader Waste Management’s first-quarter organic revenue increased roughly 5%, slightly ahead of our expected run rate on better-than-expected traditional solid-waste collection and disposal volume. Relative to the same period last year, internal top-line growth stems from the healthy core pricing backdrop, including solid yield management (increased focus on passing through rising costs) and volume gains rooted in several years of positive U.S. economic growth and impressive execution in reducing churn. Similar to previous quarters, these factors were only partly offset by recycling division headwinds linked to anemic commodity prices for key materials the firm extracts and sells, namely recycled fibers. Adjusted operating margin came in slightly below our anticipated run rate due to the timing of IT investments and an increase in litigation reserves during the quarter--factors that aren’t overly concerning.

Our midcycle revenue and margin assumptions remain mostly intact, but we expect to raise our $76 fair value estimate by 3%-4% due to boosting our 2019 top-line forecast and due to the time value of money since our previous update. The shares are trading in overvalued territory relative to our long-term expectations for the top line, profitability, and free cash flow growth. Several industry leaders are seeing robust growth within traditional solid-waste operations--with particular strength in commercial and industrial volumes--thanks to U.S. macroeconomic tailwinds, and this dynamic hasn’t escaped investors. The market also seemed to like the upcoming Advanced Waste Disposal acquisition slated for first-quarter 2020 close, as Waste Management shares pushed higher following the April 14 deal announcement. Our preliminary take is that Waste Management paid roughly a fair price--when including management’s targeted synergies, though, we think there is upside potential to the deal in terms of being accretive to our fair value estimate.

In terms of first-quarter highlights, total organic revenue increased 5.2%, reflecting an approximate 3.5% increase in total average internal volume and a 1.8% rise in average yield. Total collection and disposal organic revenue once again expanded 6% on solid 2.7% yield gains and 3.6% internal volume growth. Within this segment, commercial and industrial collection volumes grew a healthy 2.4% and 3.1%, respectively. Service increases continue to outpace service decreases, with help from positive macroeconomic tailwinds, including solid housing starts over the past several years; waste volumes tend to lag single-family housing starts by 15-plus months. Internal recycling commodities revenue fell 8.4% on the back of markedly lower average commodity prices, particularly for old corrugated cardboard, which has been hit hard by import restrictions into China.