Neutral on Waste Management (CWST) (RSG) (WM)

We are maintaining our Neutral recommendation on Waste Management Inc. (WM) based on concerns regarding lower commodity prices, electricity prices and a challenging pricing scenario. Waste Management currently maintains a Zacks #4 Rank (Sell) for the short term.

Waste Management’s second quarter 2012 EPS increased 4% to 52 cents while revenues increased 3% to $3.4 billion. However, both fell short of Zacks Consensus Estimates.

For fiscal 2012, Waste Management expects 2012 adjusted EPS between $2.15 and $2.22. Free cash flow is projected between $1.1 billion and $1.2 billion.

Volumes finally improved for a second consecutive quarter. The last time Waste Management delivered two straight quarters of volume growth was back in 2005. Volume had been on the decline due to the weak economic environment, pricing, competition and the increased focus on waste reduction and diversion by consumers. Industrial, special waste and recycling operations saw positive volume growth. Residential volumes are still lingering in negative territory, but have improved over the last six quarters. Based on the improving trend, we assume slightly positive volume growth for 2012.

Waste Management’s acquisition of Oakleaf Global Holdings will provide North American customers with unprecedented access to waste and recycling solutions by combining the largest network of directly owned hauling, recycling, diversion and disposal assets with the largest managed third-party network. Post integration, the acquisition is expected to generate a minimum of $80 million in EBITDA on an annualized basis.

Waste Management recently announced certain restructuring actions, which include doing away with certain management positions, consolidating some back-office functions, consolidating its 22 areas down to 17, reducing corporate support staff and bringing the overall headcount down by about 700. Cost savings are expected to enhance margins by about 100 basis points in 2013, and the company targets an expansion of 200-300 basis points by 2015.

On the flipside, average commodity prices have declined since the fourth quarter of 2011 which has impacted the company’s earnings. For the first half of fiscal 2012, the decline in average commodity prices dragged down earnings by 6 cents. Waste Management is expected to face commodity price headwinds for the remainder of fiscal 2012, which will likely have a negative year-over-year impact of approximately 5 cents on earnings per share.

During 2011, approximately 54% of the electricity revenue at Waste Management’s waste-to-energy facilities was subject to current market rates. The company estimates that nearly 56% of its electricity revenue at its waste-to-energy facilities will be realized at market rates by the end of 2012. The company’s exposure to market price volatility or electricity has increased over the last few years as long-term power purchase agreements have expired. Electricity prices were 8% lower in the first quarter and down 10% in the second quarter on a year-over-year basis. Electricity prices are expected to be at low levels in the second half of 2012 as well, with a negative impact of 2 cents per share on earnings.

Waste Management’s margins have been affected mainly due to the integration of Oakleaf and higher materials costs. Based on stabilizing volumes, the company plans to be more aggressive on pricing in the back half of the year. Overall, the pricing environment remains challenging and highly competitive due to aggressive bidding by smaller competitors. We do not expect any margin improvements until at least 2013.

Waste Management is the largest provider of comprehensive waste management services in North America. The company provides collection, transfer, recycling and resource recovery, as well as disposal services, to nearly 20 million residential, commercial, industrial and municipal customers. It competes with Republic Services, Inc. (RSG) and Casella Waste Systems Inc. (CWST).