Financial analysis principles and applications

Financial Analysis

Industry Analysis

The waste services industry has traditionally been a highly fragmented industry, dominated by local firms. There are approximately 15,000 companies in the industry, and they earn around $80 billion per year. While most firms in the industry remain local, a handful of firms have grown to nationwide or regional statue. The three leading firms in the industry are Waste Management, Republic Services and Waste Connections (Hoover's, 2009).

With revenues of $13.3 billion, Waste Management leads the industry with a 16.6% market share. Republic Services, with $3.7 billion in revenues, has a market share of approximately 4.6% (MSN Moneycentral, 2009). This is expected to increase to $9 billion (11.25%) in the wake of the merger with Allied Waste (Fickes, 2009). The industry is mature, with growth correlating to broad economic indicators such as GDP growth and consumer spending. The profitability of companies in the industry depends on efficient operations, since the service has become largely commoditized. There are multiple components to the industry, including waste collection, treatment and disposal and remediation. Most large firms compete in all segments of the industry while smaller firms tend to specialize (Hoover's, 2009).

In the past couple of years, the recession and corresponding slowdown in consumer spending has slowed growth in the industry. The largest firms are still, growing, however, as they acquire new territories and businesses. The trend towards consolidation in the waste services industry is expected to continue for several years. With this industry context, this paper will examine the financial performance of Waste Management, with particular emphasis on comparison to Republic Services and the industry as a whole.

Review of Financial Statements and Trend Analysis

Waste Management Inc. (NYSE: WM) has grown revenue steadily over the past few years. The company's revenue in 2008 was $13.388 billion, which represents an improvement of 0.5% over the previous year. Prior to that, revenue grew steadily, and was $12.516 billion in 2005. This represents five-year growth of 6.96%. Republic Services (NYSE: RSG) has also seen a steady five-year improvement in its top line. 2008 revenues were $3.685 billion, an improvement of 16% over the 2007 figure of $3.176. Five years ago, Republic's revenues were $2.708 billion, for a five-year revenue growth rate of 36%.

Despite steady growth in revenues, Waste Management's bottom line has flatlined, or worse. The net income for 2008 was $1.087 billion, which represents a decline of 6.5% from the year previous. The 2008 figure is also lower than the net income for the previous two years. The net income, however, is 16.7% higher than it was in 2004, meaning that despite its flatlined profit growth, Waste Management has exhibited an average five-year growth in net income that is greater than its average five-year growth in revenues.

An unusual item last year had a strong negative impact on the net income recorded by Republic Services. Net income for 2008 was $73.9 million, compared with $290.2 million the year before and $237.9 million in 2004. When the unusual expense of $172.5 million in accounted for, Waste Management's net income would have been within its normal range over the past five years. The company has generally recorded steady growth in its net income, roughly in line with the steady growth in its revenues. Between 2004 and 2008, Republic's net income improved 17.2%; its net income improved 21.9%.

In line with its relatively mature operations, Waste Management's asset base has gone nowhere in the past five years. The company's assets have eroded over that span, from $20.95 billion to $20.227 billion, although the firm did improve its asset base slightly in 2008. Liabilities have also been reduced slightly, as has owner's equity, so there is little change over the past fives in Waste Management's capital structure.

Republic grew its assets substantially 2008, after four years of stagnation. This represents a major acquisition, in which the company more than quadrupled in size. Republic absorbed Allied Waste Industries (Business Wire, 2008). Liabilities and owner's equity also increased significantly in 2008. Prior to this acquisition, Republic had seen a steady increase in its use of debt financing. The company's liabilities in 2007 were $3.164 billion, compared with $2.592 billion 2004. Long-term debt has also steadily increased over this period. With a stable asset base, this increase in liabilities has meant a reduction in owner's equity at Republic, from $1.872 billion in 2004 to $1.303 billion in 2007. The next figures make it difficult to chart trends based on 2008 figures.

Over the past five years, Waste Management has recorded a slow but steady increase in its cash from operating activities. This figure was $2.575 billion in 2008, compared with $2.439 a year earlier and $2.218 in 2004. These figures represent increases of 5.5% and 16.1% respectively. The company has for the most part had stability in its financing flows and volatility in its investing flows, the result being a general trend towards increasing cash flow over the past five years.

Republic has seen fluctuating cash flow from operations. The company has $512.2 million from operations in 2008, compared with $661.3 million a year earlier, a drop of 22.5%, yet the 2006 level was $511.2 million, almost the same as the 2008 level. The company has generally held stable with respect to cash flows from investing activities, barring its extraordinary activities last year. Financing flows as well were relatively stable until last year.

The trends for Waste Management confirm the company as a market leader in a mature industry. The firm has held steady on most key measures, and the changes in its operations on a year-over-year basis are not significant. The company may wish to address the fact that it is shrinking, but even that is not a major concern given the current state of the waste services industry and Waste Management's ability to maintain its capital structure.

Republic was trending in a similar manner to Waste Management for the 2004-2007 period, with major metrics either remaining flat or making small moves. IN 2008, however, Republic quadrupled in size with an acquisition that dramatically altered its balance sheet. Its income statement remained the same, indicating that the deal occurred late in the year. Indeed, an examination of the 2009 quarterly income statements shows a company that is much larger, having recorded slightly over $2 billion in each of the quarters, compared with revenue of $3.685 for all of 2008. What the new acquisition means for Republic's long-term financial position remains to be seen.

Analysis of Financial Statements

Waste Management is able to extract better-than-average margins for its services. The company has a 96% gross margin, which compares favorably to 39.5% for Republic and 57.6% for the industry as a whole. Waste Management's net margin is 8.0%, compared to 4.4% at Republic and 4.8% for the industry. This indicates that Waste Management has some competitive advantages that allow it to nearly double its cost of service in its pricing. The company either leverages significant economies of scale or it utilizes its market strength in order to extract higher payments from its customers. It is difficult to interpret Republic's lower than average margins because of the impact of the new acquisition on those ratios. For now, Republic does not seem able to extract high margins from its clients.

With respect to liquidity, Waste Management has a current ratio of 0.9, which is the same as its quick ratio. This compares with Republic's current ratio of 0.7 and an industry average of 1.1. Interest coverage at Waste Management is 4.5 times, compared with 2.2 times for Republic and 3.9 times for the industry overall. While neither company is in any danger of insolvency, Waste Management is in a superior financial position with regards to its obligations. Its figures are superior not only when compared to those of Republic, but to those of the industry as well. For its part, Republic's figures are not poor, but the company's liquidity and solvency clearly lag that of the industry as a whole.

Waste Management's return on equity is 14.8%, compared with 7.4% for Republic and 10.2% for the industry overall. The return on assets for Waste Management is 4.6%, versus 2.7% for Republic; with an unknown industry figure. The return on capital for Waste Management is 5.5%, compared with 3.1% at Republic and 4.0% for the industry. Waste Management also outperforms the industry and Republic on the five-year average for these three metrics as well. What this indicates is that Waste Management is a more efficient operation that is better able to convert its assets, capital and equity into profit than are the firms against which Waste Management competes.

Waste Management has a receivables turnover of 7.6 times, compared with 11.9 times for Republic and an industry average of 8.2 times. Waste Management's inventory turnover is 4.4%, compared with 97.8 times at Republic and 30.6 times for the industry. One of the most striking things to interpret from these figures is the degree to which firms in the industry carry inventory. Clearly, Republic holds very low inventory levels. Waste Management holds high inventory levels, with the industry average falling in between. This relatively inefficiency has certainly not hurt Waste Management, though, judging by the other aspects of its financial performance.

Analysis of External Environment

While nationwide there are 15,000 firms in the waste services industry, in any given market Waste Management will have only a small handful of competitors. Most of these are relatively small, being either local or regional players. Republic is one of the only competitors with a size and scale anywhere approaching that of Waste Management. Competition in any given market can vary in intensity, but competition for high stakes bids -- such as civic or large institutional bids -- can be intense. Bids are almost always based on price, highlighting the need for cost control in this industry.

The customers are waste services range from municipalities to institutions to manufacturing firms with special disposal needs that municipal services cannot meet. Remediation services also have a wide range of clients, looking for waste management solutions that cannot be handled by conventional means (removal of asbestos, oil spills, etc.). Many customers typically have high buying power as they represent large components of an area's business. Only recently have firms like Waste Management been able to counter that buying power.

The suppliers to the industry are the equipment suppliers. For trucks, dumpsters and other basic equipment, the suppliers are large industrial concerns that can dictate prices and terms to most industry players (the top firms excepted). For remediation services, however, technology is more specialized, which means that there are few suppliers and they can command a premium for their products (Hoover's, 2009).

The strategic allies of this industry are the governments in the regions in which the company operates and any potential landfill operators as well. Governments have a specific need to provide waste management services to their communities, in order to maintain the cleanliness of those communities. The governments may be responsible to waste collection contracts, but also are valuable partners in working towards broader waste management solutions and may have influence over landfill operators as well. For firms involved in waste collection, the landfill operator is a vital strategic partner. The waste collection companies work with landfill operators every day in order to move the waste from its home site to a storage location.

The main body of regulation affected the waste management industry are environmental laws. These laws dictate the degree of care that is required for the disposal of a wide range of goods. This includes case law, which sets the bounds of liability in anti-dumping cases (Koncept Analytics, 2009). Waste management firms use these laws and potential liability to help drive their own business, but they must also work within the confines of those laws in order to ward off legal difficulties themselves. Environmental laws can also impact how much waste is produced, impacting the upside growth of the waste services industry.

Sources of Funding

Waste Management's primary source of funding is through debt. There are three main reasons for this. The first is that the company has a strong position with respect to liquidity -- they have better liquidity ratios than those of their competitors. The second is that they are not in a strong position to issue more equity. Without growth to fuel interest in an equity offering, Waste Management would simply dilute the value of its stock by issuing more equity. Lastly, Waste Management has a favorable capital structure for a mature firm in a mature industry. An equity issue could jeopardize that, which minor debt issues can easily be absorbed.

For Republic Services, the Allied acquisition was paid for with equity. Republic offered 0.45 shares in Republic for every share in Allied Waste. This was made possible by Republic's strong growth, in addition to the strategic synergies between the two companies. The use of equity was necessary for this merger for two reasons. The first is that the amount of debt that Republic would have needed to absorb Allied would have crippled the company. The second is that the use of equity is commonplace for such mergers. With the strategic synergies between the two firms, it is expected that most shareholders in Allied would wish to remain shareholders in the new company. Allied management had, for example, wished to re-enter key Sunbelt markets, and a merger with Republic allowed for this.