Waste Connections (WCN) (TSE: WCN) is an integrated solid waste management services company. It provides waste collection, waste disposal, transfer, and recycling services in the U.S. and Canada.
During periods of economic slowdown or high inflation, it’s a good idea for investors to look at industries that are too essential to be greatly impacted by macroeconomic factors. The waste management business is that type of industry, as it is essential for maintaining a healthy community.
Without regular garbage pickups, cities and towns would become prone to diseases that would put a significant strain on other parts of the economy. As a result, waste collection companies will be operational in all economic environments.
Waste Connections Generates Predictable Cash Flow
Given that Waste Connections plays an essential role in communities, it is able to generate reliably predictable cash flow. Indeed, in the past decade, the company has increased its free cash flow each year, excluding 2020.
Nevertheless, free cash flow in 2020 was still very strong and not nearly as badly impacted as most other companies were during pandemic-related lockdowns. In addition, Waste Connections has also maintained a fairly consistent free cash flow margin in the last 10 years, which has ranged between 13.3% to 17.6%, although greater than 15% most of the time.
This ability to produce predictable profits is what fuels its growth catalysts.
Growth Catalysts
As one of the largest waste management players in North America, Waste Connections has the ability to grow its operations through acquisitions. In fact, that appears to be its main source of growth, as it steadily continues to consolidate what is a very fragmented industry.
However, Waste Connections has demonstrated that it can implement this approach responsibly by acquiring within its means. What this essentially means is that the money it spends on acquisitions doesn’t frequently exceed its free cash flow. This has allowed the company to avoid taking on too much debt, as it has a very healthy interest coverage ratio of 7x (measured as EBIT divided by interest payments).
Valuation
To value Waste Connections, I will use a single-stage discounted cash flow (DCF) model because its main growth driver is acquisitions. This requires a large portion of the company’s free cash flow, meaning that most of the money doesn’t actually go to shareholders.
Therefore, instead of trying to speculate how much money will be spent on future acquisitions and the impact they will have on future cash flows, I will value the company by assuming no acquisitions.
Since WCN is a mature company, it is reasonable to assume that the growth rate will be close to long-term GDP growth. Therefore, I’ll use the 30-year U.S. Treasury yield as a proxy for expected long-term GDP growth for the terminal growth rate (the growth rate the company can achieve in perpetuity).
My calculation is as follows:
Fair Value = Average FCF per share / (Discount Rate – Terminal Growth)
$70 = $3.64 / (0.085 – 0.033)
As a result, I estimate that the fair value of Waste Connections is approximately $70 under current market conditions. With its share price of around $123, the stock appears overvalued.
Wall Street’s Take
Turning to Wall Street, Waste Connections has a Moderate Buy consensus rating based on six Buys, one Hold, and one Sell assigned in the past three months. The average Waste Connections price forecast of $151 implies 22.6% upside potential.
Final Thoughts
There’s no question that Waste Connections is an essential business that should be profitably operating in all economic conditions. In addition, it has the cash flow to responsibly grow its market share through acquisitions. Nonetheless, the stock is not cheap, as investors are willing to pay a premium for its defensive qualities.
