Garbage is falling out of favor.
Shares of the two largest U.S. waste haulers prove it.
shares are down 3.6% on average in April—that is 4 percentage points worse than the Dow Jones Industrial Average’s return.
While that level of underperformance isn’t too big, Wall Street is souring on garbage, too. Less than half the analysts covering Waste Management (ticker: WM) and Republic Services (RSG) rate the stocks a Buy. Stifel analyst Michael Hoffman downgraded shares of both companies to Hold from Buy on Wednesday evening. Hoffman’s target price for Waste Management stock is $103 a share, not far from Thursday’s levels. His target price for Republic is $86 a share, about 11% higher than Thursday’s closing price.
But in the long run, these stocks could turn into a play on the recycling trend that is sure to continue to grow.
The back story: The negative sentiment shift seems strange when you consider the waste sector’s solid performance through time. Waste Management and Republic have grown earnings per share at a 12% annual rate on average for the past five years. Their stocks have gained 22% a year on average over that span. Wall Street expects annual earnings growth to average 12% for the next two years, while valuation multiples for both stocks are right in line with historical averages. With stable earnings growth and reasonable valuation multiples, what’s not to like?
What’s new: The answer lies in commodity pricing. Hoffman is cutting his earnings estimates for both companies because prices for recycled commodities such as paper, cardboard, and PET plastic bottles are falling.
Recycling is a growing business, but curiously, waste haulers don’t always get paid a separate fee for picking up recyclable goods. Instead, they rely on commodity markets to earn a return on their recycling operations. They have to sort the recycled goods and sell them into the marketplace.
Looking ahead: According to Hoffman, waste haulers are starting to go back to their municipal customers and renegotiate terms of the recycling business. But that process takes time.
Ideally, waste haulers want a flat fee to pick up household recycling and simply pass any commodity sales back to municipalities.
“We have moved most of our contracts to a processing fee-type arrangement,” Brent Bell, Waste Management’s vice president of recycling, said. That is good, but in recent years, municipalities had been accustomed to rebates from Waste Management—they don’t like having actually to pay for the service. “We’ve spent a lot of time educating our customers about where their recycled material ends up and what it’s worth,” adds Bell.
Bell thinks recycling is a good business and will continue to grow. Recycling revenue accounts for about 10% of Waste Management’s total sales.
Republic Services didn’t immediately comment.
For now, Hoffman wants to see both companies cut expectations because of weak recycling markets, before recommending the stocks again.
That certainly is something to watch for. But if valuations fall much further, waste hauling stocks could become an interesting play on the trend toward more recycling.
Write to Al Root at email@example.com