Accounting Questions, Predatory Pricing And Cash-Flow Weakness At Republic Services

| About: Republic Services, (RSG)

Needless to say, we were quite surprised with the poor first-quarter performance from Republic Services (NYSE:RSG) late last week. The sudden retirement of CFO Tod Holmes (effective May 1, 2013) didn't help the matter either, as we'd fathom that the accounting issues at Waste Management (NYSE:WM) from yesteryear were running rampant in investors' minds, particularly with Republic recently acquiring the assets of Allied Waste. We don't think there are accounting issues at Republic, but we weren't pleased with the pricing trends at the business. And while we're reiterating our view that the firm's shares remain significantly underpriced on the basis of our DCF process, we may reduce our position in our portfolios in coming days.

The trash taker's revenue advanced 0.9%, as core pricing jumped 0.6% and volume edged up 0.2% -- net acquisitions, fuel-recovery fees, and recycling commodities pricing rounded out the balance of the top-line increase. Collection and disposal revenues advanced at a decent pace, though the company experienced the biggest head winds at its recycling business, where total revenue fell to $124.1 million from $137.8 million in the same period a year ago. Much of this decline, we suspect, was due to lower recycling commodities pricing, which offered a 0.8 percentage-point head wind to revenue expansion.

On the bottom line, the company's adjusted net income dropped 11.8%, with earnings per share coming in at $0.38 during the quarter. Operating income fell to $326.9 million from $376.2 million in the same period a year ago (a decline of over 13%) as both cost of operations and overheard costs outpaced the top-line expansion. Adjusted EBITDA also performed poorly, with its EBITDA margin dropping 2.5 percentage points from the same period a year ago. The biggest changes in cost drivers, ex-fuel, were maintenance and repair expenses and labor. We think the higher maintenance-and-repair costs are largely due to the ongoing improvement of Allied's fleet of aging trucks, though management pointed to the higher cost of tires across its supplier base. Selling, general, and administrative costs (overhead) also increased rather aggressively, with salaries hurting margins by roughly 0.7 percentage points. Management attributed this increase to an increased sales staff to retain business from predators. We weren't very happy at all with this reference on the call:

"… we're very good at understanding, by market, who's taking share at our expense, and we have a sales staff that is targeted at saving business from those, call it, predators, and also making sure that we're selling accordingly into their lines of business. Because we can't just simply watch share leave as the total pie really isn't growing very much. So that all impacts churn. But again, we're very consistently using our ROI tools, our whole strategy and our compensation programs, and personally, the out-of-pie philosophy is very grounded in ROI. But we've got a good -- we always fight a good competitive fight."

Cash flow from operations dropped to $334.2 million from $433.7 million (a fall of nearly 23%), but the biggest driver behind the decline had to do with a line item called 'restructuring and synergy-related expenditures'. We found it interesting to see this line item under working capital items on the cash flow statement. Though we plan to reach out to management, we think the firm should have taken a charge on the income statement, as restructuring isn't an expense, and such a cost should be above the line. Alternatively, the company could be throwing cash at a previous charge, but we'll dig a bit deeper on this unusual line item.

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Free cash flow fell to just $64.8 million in the quarter, down from $143.4 million in the same period a year ago. Adjusted free cash flow (which considers equipment received instead of purchased) came in at $175.3 million and compares to $272.8 million in the same period a year ago.

Looking ahead, the company's outlook for the remainder of 2012 was a bit grim. Republic expects adjusted free cash flow to be at the lower end of its previous guidance range of $775 million to $800 million. Management now expects diluted earnings per share to be in the range of $1.86 to $1.90 (was $1.98 to $2.02 per share). Republic now thinks revenue expansion for the year will be roughly 1% consisting of 1 percentage points of expansion from core price, with volumes being flat (was 1-1.5% from core price and 0.5% from volume). Management also lowered its EBITDA margin expectation for the year and noted that it would benefit from a lower tax rate than last year. We would have expected an even greater downward earnings-per-share revision were it not for this tax-rate tailwind.

All things considered, we didn't like the quarter, thought the "predatory price" and "competitive fight" references were discouraging, and didn't feel comfortable with where the company accounted for its restructuring charge ("expenses"). We'll be looking to scale back our position in our actively-managed portfolios in coming days.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. RSG is included in our actively-managed portfolios.