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Republic Services: A Great Business At A Terrible Price

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About: Republic Services, Inc. (RSG)
by: Josh Arnold
Josh Arnold
Long/short equity
Summary

RSG has rallied hard this year.

The valuation has soared and the yield has plummeted.

While the business has a lot of strong characteristics, it is way, way too expensive.

Waste management generally wouldn't be the most exciting of professions. However, it is a great business. It offers a service that everyone - literally, everyone - needs and is willing to pay for, which produces reliable cash flows over the long term. The industry is still somewhat fragmented despite a couple of major players, one of which is Republic Services (RSG). Republic is a great business via just about any definition one can think of. However, that greatness has already been priced into the stock and then some, so in my view, it looks very expensive. Thus, if you're wanting to get a piece of the waste management action, I think you should wait until the red hot valuation cools off in a big way.

A great business, but not enough growth for the current price

Republic produces in excess of $10 billion of revenue annually and has a $28 billion market capitalization. It is also present in a variety of waste management sectors and has a presence in just about every state. It is one of the biggest players in the lucrative business of removing the things you don't want in your life, and that is largely the result of some careful planning from the management team over time.

Source: Investor presentation

Republic has a lot going for it, including infrastructure investments it has made over the years. These are things like modern, efficient trucks, a long-term solution for landfills, and a robust recycling network. Republic can do just about anything its customers ask of it from a waste management perspective, and it can do it cheaply. Of course, the business also offers high rates of returns on invested capital as well as free cash flow generation.

These favorable characteristics haven't gone to waste in recent years, as we can see below.

Source: Investor presentation

Republic has managed to boost EPS on an adjusted basis by 14% annually over the past three years. Some of that gain was due to tax reform - which Republic had nothing to do with - but the point stands that it has been able to produce steady growth over recent years. The same is true with free cash flow as the company's robust profitability affords it the ability to return lots of cash to shareholders.

In fact, Republic has returned just over 100% of the cash it has produced in the past three years to shareholders via the dividend and share repurchases. That's not only a testament to management's commitment to shareholders but the ability of the business also to run profitability with relatively little capital investment. Personally, I like Republic's mix of dividends and share repurchases, as some businesses try to just distribute most or all of their excess cash to achieve the highest possible yield; Republic is trying to reduce the float over time while providing meaningful cash to shareholders.

Source: Investor presentation

The party is continuing in 2019 as the company reckons it will return ~$900 million to shareholders via dividends and buybacks while spending another $550 million on acquisitions. Acquisitions are a common activity for Republic as it builds scale via purchasing rather than waiting for organic growth. There are plenty of independent and smaller operators in the waste management business, so Republic's acquisition pipeline will be limited only by its ability to pay for acquisitions in the future; there will be no shortage of targets.

Republic's earnings growth has generally been in the mid-single-digits, or perhaps slightly higher or lower, over time. There have been outliers, but, on average, it is reasonable to expect the combination of acquisitions, organic growth, and share repurchases to produce something like 5% to 7% EPS growth.

Source: Investor presentation

Republic reckons it will produce under 6% EPS growth this year according to the midpoints of the guidance ranges above. As mentioned, that's about normal for Republic, which is respectable, but a very long way from being spectacular.

This presents a problem when viewed in the context of the way the stock has rallied this year and indeed, in recent years, in general. To illustrate my point, I have a couple of exhibits that I believe represent clear evidence that Republic's EPS growth rate cannot reasonably be expected to be materially higher than it is today, which, in my view, means shares are overvalued at 27 times earnings.

Cracks in the armor

First, Republic's margins haven't really moved for several years despite ever higher revenue totals, as you can see below.

Source: TIKR.com

Since 2016, revenue has steadily moved up from just over $9 billion to more than $10 billion, and what is likely to be close to $11 billion in 2020. However, we can also see that EBT margins, which is earnings before taxes, have been stagnant all those years. Generally, when a business thrives on scale, such as waste management, revenue increases disproportionately boost margins as fixed costs are leveraged down. However, that simply hasn't been the case. Even if the forecast gain in EBT margins for next year comes to fruition, EBT margin will be essentially in line with 2016's levels. If it doesn't, EBT margin will likely be below 2016's levels. Thus, it is unreasonable to expect margin expansion to play any sort of role in EPS in the coming years. Republic hasn't capitalized on additional scale yet, so there is no reason to think that will change.

Second, Republic's business has a very high correlation to economic strength, as measured by housing starts.

Source: Investor presentation

As we can see, Republic believes its volume figures have an 88% correlation to single-family housing starts on a one-year lag basis. In other words, when housing starts decline, as they always do during recessions, Republic's volume will suffer. The damage won't be immense by any standards, but given that we are more than a decade into the current recovery cycle, it stands to reason we aren't particularly far from this occurring again. I don't claim to know when the next recession will be, but this chart tells me that Republic will be vulnerable on some level when it does. Again, given the lateness of the current cycle, I'm not sure bidding the stock up right this second is prudent.

Why does all of this matter? Because this stock is really expensive, even after a recent pullback.

Source: Author's chart using data from Seeking Alpha

Above, I've charted Republic's average PE ratios and yields for the past decade to give us some historical context on its recent moves. The company's average PE ratio for the past decade is 21, while its most recent five-year average is 24.5. The past three years have seen stratospheric multiples applied to a business that is growing at ~6% a year, which I simply don't get.

I understand Republic is in a very stable industry that allows for gradually increasing dividends and share repurchases. However, I also think at some point, actual growth has to come into the equation, and I wouldn't pay 27 times earnings for any business with a long-term growth rate of 6%, or anywhere close to that value, for that matter.

Republic's valuation is egregious, and its yield is as low as it has been at any point in the past decade, despite the fact that the company faithfully raises its payout every year. The stock is just so expensive that the yield is now under 2%, which means Republic isn't even an attractive income stock any longer. Yields were near or above 3% for years, but at under 2%, it is not an interesting income option any longer.

The bottom line is that Republic is a wonderful business for a variety of reasons. The problem is that it is way too expensive as overzealous income-seekers have bid the stock into the mesosphere and beyond in recent years. I like Republic but it has been closer to its long-term average valuation for me to take a look because despite all of its goodness, this company isn't any better off today than it was five years ago from a growth perspective. Given that, why should I pay a huge premium? I don't think I should, and those of you that own it should consider selling to buy it once it is rationally priced again. I'd be interested at a valuation of 22 times earnings or below, but that is a long way down from here, equating to a share price of $77 on next year's guidance range.

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.