By The Valuentum Team
Garbage picking may not be a glamorous business, but someone's got to do it. Not only is it a necessary and essential service, but humankind doesn't quite have the technology (yet) to make the world 100% recyclable and/or trash free. That means landfills will continue to be a part of the trash cycle, and for those companies that have massive disposal capacity, including Republic Services (NYSE:RSG), times will be good for some time to come. Let's put it this way - citizens aren't all that happy about the idea of new landfill construction, so those that have disposal sites have assets that are near-irreplaceable.
While technically anyone that can finance a truck and bid on a municipal contract can enter the garbage collection business, Republic's purchasing scale and sharing of best practices make it one of the best plays in garbage, in our view. The company's deal to scoop up Allied Waste some years ago was a great one, and we believe the combined entity continues to reap the rewards. My goodness - look at its share price during the past few years. We don't want to overreact though, but shares are starting to get a bit pricey after their run-up (see Valuation section below), but its dividend remains attractive, even if it, too, may not be as strong as it once was, given residual debt from the Allied takeover.
Though no company is without risks, we like Republic a lot. We include it as one of our best ideas in the Best Ideas Newsletter portfolio. Learn more about our Best Ideas Newsletter here. Let's have a look.
Republic Services' Investment Considerations
• Republic Services is the second largest provider of services in the domestic non-hazardous solid waste industry, as measured by revenue. The firm has ~340 collection operations in ~40 states and Puerto Rico. It owns and operates ~190 active solid waste landfills. The company was founded in 1996 and is based in Phoenix, Arizona.
• Republic's enormous Apex regional landfill in Clark County, Nevada, is the busiest facility in the US and should enjoy years of strong cash flow generation from one of the fastest-growing areas in the country. It may be the crown jewel in the waste industry.
• In 2016, Republic Services expects revenue to advance at a 2.5%-3% pace and diluted EPS in the range of $2.13-$2.17. Management plans to hit the range in adjusted free cash flow of $820-$840 million, which compares to reported levels of ~$815 million during 2015.
• Republic Services is expecting strong pricing in 2016, and volume growth in a range of 1%-1.5%. Key contract losses are likely to push residential volumes to be slightly negative. The firm's EBITDA margin is expected to improve to 28.5%, and multiple tuck-in acquisitions can be expected in the year.
• Republic's disposal assets represent a long-term strategic benefit that will only become more valuable over time due to an increasingly onerous regulatory environment and continued citizens' group opposition to greenfield sites.
Republic Services benefits significantly from its long-term disposal assets. Such assets grow more attractive as time passes, thanks to the increasing regulatory nature of the waste business, as well as citizen groups opposed to greenfield sites growing in number and strength. These disposal assets, including its Apex landfill in Nevada, which is the busiest facility in the US, represent the material barriers to entry that give the company a large portion of its moaty characteristics. We like management's near-term growth targets, and pricing power is another competitive advantage the firm benefits from as a result of it operating in a monopoly in ~30% of its markets. Free cash flow has been sufficient in covering annual cash dividend obligations in recent years.
Republic Services' debt load provides a large drag on its Dividend Cushion ratio; as of the end of the first quarter of 2016, the company's net debt position stood at more than $7.5 billion. However, less than $10 million of that debt will mature in 2016 and 2017 combined. Though we note that annual free cash flow generation has been enough to cover annual cash dividend obligations, when considering the additional capital used to repurchase shares in recent years (over $400 million in both 2014 and 2015), such coverage becomes stretched. Tuck-in acquisitions have the potential to impact the pace of dividend expansion moving forward, but we continue to expect modest increases in its payout on the back of its stable, free cash flow generating operations.
Read more about its dividend here.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Republic Services' 3-year historical return on invested capital (without goodwill) is 16.7%, which is above the estimate of its cost of capital of 8.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Republic Services' free cash flow margin has averaged about 7.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Republic Services, cash flow from operations increased about 8% from levels registered two years ago, while capital expenditures expanded about 7% over the same time period.
We think Republic Services is worth $44 per share with a fair value range of $35.00-$53.00.
The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3.2% during the next five years, a pace that is lower than the firm's 3- year historical compound annual growth rate of 3.9%.
Our model reflects a 5-year projected average operating margin of 17.9%, which is above Republic Services' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For Republic Services, we use an 8.9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $44 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Republic Services. We think the firm is attractive below $35 per share (the green line), but quite expensive above $53 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Republic Services' fair value at this point in time to be about $44 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Republic Services' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $56 per share in Year 3 represents our existing fair value per share of $44 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: RSG is included in the Best Ideas Newsletter portfolio.