2023-05-30 05:01:38 ET
Summary
- Republic Services is a waste management company well-positioned to benefit from the growing trend toward recycling and environmental solutions, with a strong focus on customer service, digital innovation, and sustainability.
- The company is developing innovative methods to convert waste into profitable resources, such as extracting methane from waste for energy production, implementing advanced automation technologies in recycling facilities, and converting plastic into reusable materials.
- With a solid balance sheet, consistent free cash flow growth, and a track record of dividend increases, RSG offers shareholder value and stability, making it an attractive investment for those seeking long-term outperformance in a defensive dividend stock.
Introduction
I'm sure most of you know that I really like buying companies that have a stronghold in important supply chains. My portfolio includes (among others) railroads, aerospace suppliers, healthcare firms, and utility companies. I've had my eye on waste management companies for a while, but I never got around to digging into their financials and the bigger reasons to be bullish. Well, that's about to change with this article.
In this piece, I'm going to tell you why Republic Services ( RSG ) has made it onto my watchlist. It's a waste management company that's riding a major trend that could turn trash into treasure.
This environmental trend is a huge boost for companies that can recycle and do all things related to it, making the long-term bullish case even sweeter.
So, let's not waste (pun intended) any more time and dive into the details!
What's Republic Services?
With a market cap of $45 billion, Republic Services is the second largest waste management company behind the company that is actually named Waste Management ( WM ).
The company operates in the industrial sector. I'm heavily overweight industrial stocks already, as 48% of my dividend portfolio is invested in industrials.
However, half of that exposure is invested in defense contractors, which are anti-cyclical. Also, the waste management industry is somewhat anti-cyclical. While higher economic growth does come with more waste, it's not an industry that runs into trouble the moment the economy runs into trouble.
With that said, Republic holds a significant position in the North American environmental services/waste management market, which generates an estimated $107 billion in annual revenue.
This market includes both the recycling and solid waste industry, valued at $78 billion, and the broader environmental solutions industry, valued at $29 billion.
Republic's growth strategy focuses on market verticals with above-average growth rates and attractive return profiles, driven by its unique capabilities in customer service, digital innovation, and sustainability.
Headquartered in sunny Phoenix, Arizona, the company has roughly 5 million daily pickups using 17 thousand trucks, 72 recycling centers, 206 active landfills, 240 transfer stations, and a network of more than 40,000 employees.
Roughly 80% of the company's business revenue has an annuity-type profile. Waste collection accounts for 70% of its revenue.
The company's business isn't just anti-cyclical, it also has strong pricing power. Half of its pricing strategy relies on the open market, which allows the company to secure price increases directly with customers. In 2022, the company had 6.7% core price increases in that segment, allowing it to deal with high inflation.
17% of its prices are linked to the CPI. Other structures include fixed price hikes at 4% or higher and cost-based alternatives.
With regard to my anti-cyclical comments, RSG's demand is driven by population growth, household formations, and new business formations. According to the company's own calculations, volume growth has a 90% correlation with housing starts and a 70% correlation with GDP growth. While this might suggest that the company is cyclical, it needs to be said that the impact of these two indicators is limited to overall volume growth.
In its 10-K , the company writes that it believes that its products and services are essential for long-term sustainability and that a strong focus on sustainability attracts top talent, increases customer loyalty, and ultimately drives higher revenue and profits.
This is correct. Also, sustainability isn't just a buzzword here, it could be the next big megatrend in its industry.
Sustainability Could Take RSG To The Next Level
Republic Services is proof that investors don't need to invest in complicated technologies and niches to find outperformed. Republic Services, for example, has returned 405% over the past ten years, beating its peer Waste Management by roughly 25 points and the market by 200 points.
This outperformance came with extremely subdued volatility and an anti-cyclical business model.
Now, we're likely at a point where the company benefits from a secular tailwind that could mean a continuation of past outperformance.
As reported by the Wall Street Journal , investors are looking for the next big thing in an unusual area: garbage.
Analysts believe that garbage management companies are well-positioned to capitalize on efforts to reduce greenhouse gas emissions and promote material reuse.
In response to environmental initiatives, Waste Management and Republic Services are developing innovative methods to convert trash into profitable resources.
They are building plants to extract methane from decomposing waste and integrate it into the natural gas grid for energy production. Recycling facilities are being equipped with advanced automation technologies to efficiently sort and process materials, meeting the demand from consumer goods companies aiming to minimize landfill waste and ocean pollution.
Republic Services, with its joint venture with BP, is installing gasworks in its landfills to generate electricity and supply utility pipelines.
Republic Services is also investing in polymer-processing facilities to convert collected plastic into reusable flakes, meeting the requirements set by states and consumer-product companies regarding post-consumer content and sustainability goals.
In its 1Q23 earnings call, the company was asked about these tailwinds. I added some emphasis.
Q: [...] can I trouble share with us the incremental tailwinds to your business from the plastics and landfill gas investments that are scheduled to come online for '24 versus '23 and '25 versus '24 . When do we get the most significant step up relative to the cadence?
A: [...] let me start with the plastic side on the polymer center. We start to see that in '24, start to layer in with, call it, $15 million or so of EBITDA, and then it really ramp up into 25 and into 26 and until you get to a run rate of, call it, somewhere in that $75 million plus type EBITDA range. When you take a look at from a gas perspective, again, most of that, you're starting to see, again, you start to see the first projects come online towards the end of '23. So most of the contribution coming in '24 , you could see $25 million plus type of incremental EBITDA in '24 and then sequentially in a $15 million to $20 million per year until we get to that $100 million worth of total contribution by 2028 .
While $100 million in incremental EBITDA doesn't turn RSG into a growth business (it's roughly 2.6% of 2022 EBITDA), it does provide the company with a new long-term tailwind that - I believe - can be expanded with new capabilities in recycling and energy generation.
Also, this does not expose the company to more volatility. While dealing with gas means dealing with a cyclical and volatile commodity, companies like Republic Services argue that these ventures are supplementary and profitable, even during times of low commodity prices.
Furthermore, WSH noted that last year's climate bill sweetened the economy of trash gas (I like that name), as it offers additional credits for biogas projects that produce power for electric vehicles.
Related to my aforementioned profitability comments, companies like RSG don't need incentives to be profitable in that area. According to the WSJ:
Landfill gas is essentially the only scalable biofuel that doesn't have a food-for-fuel trade-off," said Goldman Sachs analyst Jerry Revich. "These projects don't need any subsidies, but they will take the free money.
Where's The Shareholder Value?
With that said, let's zoom out a bit.
Republic Services is both a cash cow and a company with solid long-term growth. Not only does the company have a 4.3% 2023E free cash flow yield, but it also grew its free cash flow by almost 150% over the past ten years. The free cash flow growth rate was twice as high as the revenue growth rate.
Furthermore, the company has a healthy balance sheet. Using 2023 numbers, the company has a 2.6x net leverage ratio. Its average cash interest rate is just 3.5%. It has $2.5 billion in available liquidity and no major maturities in 2023. It has a BBB+ credit rating, which is one step below the A-range.
This balance sheet could have been a lot healthier if it wasn't for the company's M&A, which boosts revenue and eventually leads to an even better balance sheet.
Last year, for example, the company bought US Ecology in a $2.2 billion enterprise value deal. The company, which used to trade under the ECOL ticker, is a leading provider of environmental solutions offering treatment, recycling, and disposal of hazardous, non-hazardous, and specialty waste.
Going forward, the company has the balance sheet for newly acquired growth whenever it sees potential synergies.
In its 1Q23 earnings call, the company mentioned that the pipeline for special waste opportunities remains robust, with about 20% of the pipeline attributed to cross-selling opportunities. The company is excited about the momentum and sees significant potential for future growth in this area.
That said, the company has a 1.4% dividend yield. A 1.4% yield isn't something to write home about. However, it comes with a lot of safety and consistency.
- Republic Services yields 1.4%, which is roughly 20 basis points below the S&P 500 yield.
- It has had 19 consecutive years of dividend growth.
- Its payout ratio is below 40%.
- The five-year average annual dividend growth rate is 7.5%.
- On August 4, 2022, the company hiked its dividend by 7.6%.
Furthermore, over the past ten years, RSG has reduced its share count by 12%.
With regard to the aforementioned free cash flow comments, RSG isn't expected to grow its free cash flow until at least 2025.
This is solely based on higher capital expenditures, as RSG is investing in its future and integrating new businesses.
In 2022, the company had $1.5 billion in CapEx (11.1% of its revenue). That number is expected to gradually rose to $1.9 billion in 2025 (11.4% of expected revenue).
While this might seem like bad news, free cash flow will remain close to 5% of its current market cap, which means the cash dividend payout ratio remains close to 30%.
Also, it paves the way for higher EBITDA growth down the road.
- In 2023, EBITDA is expected to grow by 9.9% (on top of 16% growth in 2022).
- Next year, EBITDA growth is expected to be 7.2%.
- In 2025, EBITDA is expected to grow by 6.5%.
Valuation
RSG isn't cheap. Shares are up 9.4% year-to-date and just 5.5% below their 52-week high. Shares are up 18% from their 52-week lows.
FINVIZ
Using 2024 numbers, RSG is trading at 12.0x EBITDA. It's trading at 14.8x LTM EBITDA. In other words, investors have priced in above-average growth since 2021.
Given my high industrial exposure and subdued cash position after some aggressive recent investments, I'm in no rush to chase the RSG stock price at $140.
While I believe that RSG is fairly valued (the consensus target price is $154), I'm looking for a potential stock price decline to the $120-$130 range. The close to $120 it gets, the more likely I'm going to buy this stock.
I also believe that this stock is perfect for a few accounts that I indirectly manage/advise. Especially for people who are 10-15 years away from retirement and prefer a mix of growth and value.
If I get RSG at the right price, I will likely push the buy bottom in a few accounts, as I believe that RSG is a fantastic defensive dividend stock with a high likelihood of long-term outperformance.
My buy rating reflects the longer-term outlook.
Takeaway
Republic Services is a waste management company with a significant position in the North American environmental services market. With a strong focus on customer service, digital innovation, and sustainability, the company is well-positioned to benefit from the growing trend toward recycling and environmental solutions. RSG's business model is anti-cyclical with strong pricing power, allowing it to navigate economic challenges and inflationary pressures effectively.
The company is embracing sustainability initiatives by developing innovative methods to convert waste into profitable resources. Through partnerships and investments, RSG is extracting methane from waste for energy production, implementing advanced automation technologies in recycling facilities, and converting plastic into reusable materials. These initiatives provide a long-term tailwind for RSG and contribute to its growth potential.
With a solid balance sheet, consistent free cash flow growth, and a track record of dividend increases, RSG offers shareholder value and stability. The company has also engaged in strategic acquisitions, expanding its revenue base and potential for future growth. While RSG is trading at a premium valuation, patient investors may find opportunities to buy at a more favorable price range, particularly around $120-$130.
For further details see:
Republic Services: Turning Trash Into Wealth