RealMoney Silver - Allied Waste Could Be Traders' Treasure

Allied Waste Could Be Traders' Treasure
By Bill Trent
RealMoney.com Contributor
4/7/2008 2:51 PM EDT

After underperforming its peers Waste Management (WMI) and Republic Services (RSG) for the last few months, Allied Waste (AW) looks poised for a rebound. On the basis of my valuation, I believe the shares are worth $14 to $14.50, or about 25 to 30% higher than the current price.

Allied provides collection, transfer, recycling and disposal services for more than 8 million residential, commercial and industrial customers. It is the second-largest non-hazardous solid waste management company, with an estimated 11.7% U.S. market share, according to its most recent 10-K filing.

The construction industry downturn has reduced waste volumes, and the trend is expected to continue in 2008. However, price increases allowed Allied to boost revenue 3.7% in 2007, and further hikes of 4.5% should allow the company to meet its 2008 revenue growth target of 1.5-3.0%.

Although Allied Waste shares have seen significant short-covering in recent weeks, I suspect that much of the change was due to arbitrageurs playing the convertible preferred stock. The preferred was automatically converted into common shares on March 1. The conversion doesn't affect the fully diluted share count (as the preferred was already included) but will reduce cash dividend payments by $37.5 million per year.

Partly as a result of the conversion, and partly because Allied has taken steps to improve profit margins, estimates for Allied Waste have been inching upward over the last 30 days. In contrast, both Republic Services and Waste Management are seeing downward estimate revisions.

Allied Waste generated $396 million in free cash flow in 2007, amounting to an 8.3% free cash flow yield on the basis of current market capitalization. Unfortunately, this year the cash flow is spoken for. To avoid further penalties and interest related to some unresolved tax issues, the company paid $196 million for tax and interest related to its1999 income tax return. Later in 2008, it expects to pay the IRS and other tax authorities about $155 million.

Still, settling these obligations is a one-time use of cash (and may be reversed in future periods, depending upon the outcome of their disputes). Looking past that, the 8.3% free cash flow yield for Allied compares quite favorably with the 6.7% yield at Republic and 7.2% for Waste Management, particularly in light of the relative earnings momentum.

All three companies are expected to grow their earnings by about 11% per year over the next five years. However, Allied looks much cheaper than its peers, trading at 1.15 times book value compared with 2.9 times for Waste Management and 4.2 times for Republic.

Allied could achieve double-digit annual growth in its share price over the next ten years simply by expanding its price/book ratio to the level of Waste Management's. If the company also manages to grow at the expected 11% per year, the total return could prove impressive indeed.

Allied stock has challenged the $14 mark several times over the last five years. I believe it is due for another run at that level; that would require nothing more than meeting estimates and a modest increase in the price/book ratio to about 1.3 times. A free cash flow yield of 7% (the average of its peers) would also support a $14.50 share price.