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Out on a Limb with:
WASTE MANAGEMENT INC (WMI)
Who's out there? The management team of Longleaf Partners fund, led by Mason Hawkins.

How far out? As of June 30, 2000, Waste Management made up 17.6% of the the Partners' fund portfolio ($569 million).

What's the problem? USA Waste Services bought the much larger Waste Management Inc. in July 1998, and adopted its name. The computer and accounting systems of the new company were inadequate from the start, and soon there were delivery and billing problems. In July 1999, WMI twice lowered its earnings estimates for the second quarter, it had to restate first quarter earnings due to accounting problems, and it later lowered earnings estimates two more times. The stock got hammered, falling from about $54 per share in June 1999, to on June 30, 1999 to a low of about $13 in March 2000.

How has the stock been performing?

What is the fund manager saying? "Waste Management, our largest position, posted solid first quarter results that indicate Maury Myers and his new management team have stabilized the business. The stock rose 39% in the second quarter. The company has reported both volume and pricing increases and an improved working capital position. Non-strategic asset sales are on target to raise $3 billion. The company received a favorable settlement with the SEC, and a lead plaintiff has been chosen for shareholder suits. We are delighted but not surprised by the progress. WMI remains deeply undervalued relative to the free cash flow it currently generates. We anticipate rapid value growth as Waste fully converts its computer systems and Myers implements operational best practices throughout the company." [Mason Hawkins and Stanley Cates, from the 6/30/00 shareholder report]

What are other people saying? Several analysts have raised their ratings on WMI, based on higher-than-expected first quarter 2000 earnings, and the absence of any new, unpleasant surprises. Still, this is a company that's clearly on probation with the market. If there are no earnings (or other) surprises for the next 12 months or so, the company's credibility might be restored, and the market might start to pay attention to the company's fundamentals. But if there's even one more unpleasant surprise in the next year or so, earnings-related or otherwise, you get the feeling that all hell could break loose, and this stock could fall even further than it has.

FundAlarm comments: There appear to be two, distinct issues with this stock: (1) Is WMI a good buy at its current price, around $19 per share?, (2) Is WMI a stock that Longleaf Partners should have held on the way down, and should continue to hold today?

One could easily conclude that WMI is a good buy today, but still conclude that Hawkins made a big mistake not selling out at the first sign of trouble in July 1999. We've searched all of the Longleaf reports since WMI was first acquired, and we can't find a single reference to Longleaf's average purchase price for its WMI shares. Therefore, it's impossible to know how far the stock has to climb just for the Partners fund to break even. At least one analyst has suggested that WMI could climb to $30 per share within 12 to 18 months, and that doesn't seem impossible. But we have a feeling that even at $30 per share, the Partners fund would still be under water with its WMI investment. And then what? Even if WMI claws back to $30 per share by this time next year, and the stock has normal appreciation thereafter, it still has almost two years of opportunity cost to make up for fund shareholders.

In our opinion, Hawkins has allowed the Partners fund -- and maybe his career -- to be held hostage by one company. That's a position no fund manager should stumble into, no matter how well-run a company is. And WMI has not been a well-run company. As things stand now, Hawkins is going to live or die by the accuracy of WMI earnings estimates, and the quality of its accounting staff, for a long, long time. We don't envy him.