2023-04-19 16:40:34 ET
Summary
- Republic Services is steadily growing revenues despite its already large position in the market with the help of effective acquisitions.
- The waste management industry is a necessary part of our society, and RSG has an incredible retention rate, creating predictable future earnings.
- But valuation matters even when a company has solid fundamentals, and paying around 26x forward earnings for Republic Services is more than I am willing to do.
Investment Summary
Operating across 41 states, Republic Services, Inc. ( RSG ) is a major solid waste management provider in the United States. Its services include solid waste collection, transfer, recycling, and disposal. Republic Services caters to a wide range of clients, including residential, commercial, and industrial customers, and offers a variety of waste management solutions.
This wide network and the strong position in the industry have made the company able to grow with the market and the last earnings report highlighted the company's strong performance with revenues increasing 19.6% on a yearly basis, with almost half being from acquisitions. I think RSG really shows what a quality company is all about, good margins, growing free cash flows, and good outlooks. But the valuation is in my opinion too high now to really make a strong buy case. Paying 26x earnings is too high, even for a company like RSG. I think, however, holding onto Republic Services, Inc. shares is the better option.
A Growing Industry
One of the benefits of investing in a company like RSG which has perhaps one of the most necessary services for our society, waste management, is that the market will always be there. Someone will always have to collect trash and process waste. This makes it easier in my opinion to predict the performance of companies within the sector. In an investor presentation in February, RSG highlighted this, too.
When 80% of the revenues are annuity-type, it makes it easier for the management to make investments as they know they will have money coming in, nonetheless. In a report by Polaris Market Research , they predict the waste management industry to experience a 5.4% CAGR between 2021 and 2030. I think given the large market share that RSG has gotten, it's not impossible for them to grow at this rate annually, too, just from a sheer revenue increase YoY. My prediction of this is also based on the fact that RSG has a 94% retention rate, as they showed in the presentation. As I mentioned in the first part also, the company is very keen on making acquisitions to establish its place in the industry and also keep revenues growing. In the last 3 years, they have invested $4.4 billion into this strategy, and with cash flows remaining strong and predictable, I think they will continue making investments.
Risks
Looking at the risks facing RSG, I think they lie within the company instead of market risks. As I have said before, the waste management industry is necessary , and it's unlikely it will lose demand from it.
The first thing that pops out is a large amount of debt the company has right now and has built up over the last few years. Between 2013 and 2019 it remains quite stable, but as interest rates were very low, the company took advantage of this and took on more. Sitting at around $11 billion right now, I think it's a cause for concern as the TTM levered free cash flow is $1.3 billion. I would have preferred the company to have more of an ability to pay off significant amounts of debt. The priority seems to be to make these acquisitions to keep revenues increasing, but if it ever backfires the cash cushion the company has is not that large, only $143 million. As it seems we are heading into a more challenging economic environment, I would have felt safer investing in the company if there was a better financial situation for them.
Financials
The balance sheet has had some notable changes between 2021 and 2022. The company's total assets increased by $4.1 billion to $29.1 billion in 2022, up from $24.9 billion in 2021. It is a good sign to see the cash position of the company increasing by a pretty significant amount, from $29 million to $143 million. But looking at the debt, which was mentioned before, it does little to quench concerns. But it's a move in the right direction at least. Instead, much of the increase in assets was caused by an almost $2 billion higher goodwill compared to 2021. I don't place too much importance on this, so the $4 billion richer asset side of the balance sheet might not be that "newsworthy." The property and equipment increased by around $1.5 billion though, so it will be interesting to see how the ROA will increase as the company leverages these investments to boost revenues.
Long-term debt increased by $1.8 billion to $11.3 billion in 2022, up from $9.5 billion in 2021. I have mentioned in the risks section that I think the debt is a cause for concern when the cash cushion the company has is so small and almost all the cash flows are going to making acquisitions instead. Eventually, there will need to be a shift in priorities and I think that's when the growth phase is over and the company goes into a stage of paying back large amounts of debt and perhaps slowing down share buybacks also.
To conclude the balance sheet quickly, I think there are some very necessary moves I'd like to see the company make to bolster a potential investment case. Building up a larger cash position and slowing down the number of debts that are being taken on is a start. But for now, they seem to have a manageable situation as the cash flows are both large and highly predictable too.
Valuation & Wrap Up
I based the hold rating for Republic Services, Inc. mostly on that I don't see the valuation right now as low enough to encourage a strong enough buy case. Paying around 26x forward earnings, even if they are increasing at a good yearly rate, is too high for me. I would much rather pay something around 18-19, which would be around $98 per share. It's a fair bit below the current price, but I believe strongly in not overpaying for companies even if they have consistently good performances like RSG.
Looking at some peers in the industry, it seems to have been an ongoing trend that waste management companies trade at a high valuation. Waste Management ( WM ) is trading at around the same forward earnings multiple, and Waste Connections, Inc. ( WCN ) is even higher at p/e 33.
I think that right now we need to wait for multiple compression in the industry before investing in anything. Out of those 3, though, I think Republic Services, Inc. looks the best, as they have the highest gross margins, lowest forward earnings multiple, and a decent dividend at around 1.42%. So for right now, I think Republic Services, Inc. is a hold and potentially a buy if we see a significant compression in the valuation for the industry as a whole.
For further details see:
Republic Services: Despite Good Growth, It Doesn't Scream Value